To PE, or Not to PE?

That's the question most investors need to ask themselves.

The price-to-earnings (PE) ratio has become one of the most commonly used tools in finance. It's the simplest valuation metric to gauge how expensive or cheap a stock is.

The general idea is that stocks with low PEs are better than stocks with a high PEs. But therein lies the trouble...

The PE ratio is not necessarily always the truth and other valuation metrics could be more useful in different scenarios.

Allow us to explain...

PEs in Different Industries

For companies operating in cyclical industries - where earnings peak and then fall and then scale another peak - PEs will always look most attractive during economic boom.

This is a trap. Investors must consider the PE for the entire cycle rather than just one year's earnings.

On the other hand, companies operating in growth industries command better valuations than their cyclical counterparts.

That's why it's important to always consider the sector when valuing a stock.

Low PE vs High PE

Just as low PE does not necessarily indicate an attractive stock, a high PE can also mislead. It often happens that a quality company will perform badly owing to some unforeseen circumstances or an unavoidable industry slowdown.

At such times, since the earnings suffer, the PE ratio could appear to be on the higher side. However, this does not mean the stock has become less attractive; on the contrary, this could be a good opportunity to invest in a turnaround story.

It's the Denominator That Matters

PE < 10 = buy stocks. PE > 20 = sell stocks.

Simple? Well, yes and no. You have to decide how you're going to calculate PE. Forward earnings? Last year's earnings? Earnings averaged over ten years? Normalised earnings?

Most of us calculate PE based on last year's earnings or trailing twelve months (earnings of the previous four quarters).

However, when we buy we stock, we are betting on future earnings.

Think of it this way: A stock with a low PE would fail to generate good returns if its business is stagnant. No growth would mean suppressed earnings and not much return for the shareholders.

On the other hand, a stock with high PE can create massive wealth if its earnings grow consistently.

That is why earnings growth the most important driver of stock returns in the long run.

So don't only consider trailing multiples when you calculate PE ratios. Also pay regard to future earnings potential. Even if your PE calculation is based on historical earnings, keep an eye on the future growth of the business.

Other Valuation Metrics

As we've seen, applying PE to commodity companies can be misleading during a cyclical peak and trough. For such stocks, we drop this valuation metric in favour of the more reliable PBV (price to book value).

Since commodity profits largely depend on the company's scale of capacity, higher capacity means higher profits. Moreover, as more capacities are financed by equity and internal accruals, the better it gets. Capacities financed by internal accruals mean a higher book value and thus a higher valuation.

Furthermore, just as PBV is a more reliable valuation tool for commodity companies, other metrics - like the PCF (price to cash flow) or PS (price to sales) - lend themselves to the analysis of certain industries more than PE.

The auto industry is a good example. During times of high capex, when an auto company is working on a new platform or coming out with a new model, earnings may appear depressed and the stock might look less attractive on account of the higher PE. In this case, PCF would give a better picture, as it would capture the benefits of the company's capital investments, which will accrue in the coming years.

To PE?

Considering one valuation metric in isolation has its risks. To minimise error, always check at least two valuation tools.

Depending on the fundamentals - such as earnings track record, management, financial leverage, cash flows, return on capital, etc - every company should command a certain PE or a sector-specific ratio.