Can P/E Be Overvalued?

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By Vince Hanks
June 22, 2000

The price-to-earnings ratio (P/E) has long been revered by investors as a paramount stock analysis tool used in determining the relative value of an investment in relation to its price. Arrived at by dividing the company's market capitalization by trailing twelve-month earnings, the P/E ratio tells investors how much they would pay for a dollar of earnings per share. Although the P/E has enjoyed decades as the universal measure of stock value, a current wave of sentiment is sweeping Wall Street that suggests the P/E may be overvalued.

"I think it may have gotten a little ahead of itself," said Jonathan Sparks, a senior analyst with Merrill Lynch. "It can't be expected to sustain that kind of meaning in today's economy."

Skepticism regarding the P/E's current value gained momentum recently in the wake of several applications of the metric to companies that have recently achieved profitability.

"You can't use every tool in every situation," remarked Lydia Waters, CNBC value expert. "Companies such as Yahoo! and America Online that have just recently turned profitable have very little earnings in relation to their potential going forward. Naturally, a P/E ratio would be sky-high in these cases. It's a measure of today, not a gauge of expanding possibilities."

Not everyone agrees. Stan Humpreys, a lead value writer at Barron's, suggests, "Overvalued, smovervalued. I think, if anything, the P/E ratio is undervalued. It should be used for the newly profitable, the nonprofitable, even those so-called 'hypergrowth' Internet whatchamacallits. The future is much too uncertain to be attached to any possible reward."

Still, the concern over P/E value is growing, and a smattering of analyst downgrades have followed.

"It's purely based on current valuation," said James Haller, an analyst with Lehman Brothers. "We're lowering our rating on the P/E ratio from 'near-term accumulate to 'scatter about the room haphazardly.'"

Fran Blancher of PaineWebber was reached vacationing off the coast of Madagascar. "We're maintaining our 'buy' rating. But we're adjusting it down a bit to 'buy less enthusiastically.' We feel the P/E ratio is being used out of context. Earnings just aren't always a useful measure of success, especially in the early stages of a business. Mature businesses with consistent earnings are much more appropriately suited for a ratio such as this."

Finally, Steven S. Carter weighs in from USB Piper Jaffray. "Due to the exuberant run-up in misplaced P/E ratio emphasis, we're lowering our rating from 'it's all good' to 'hmmmmm.' However, we expect a slowdown in earnings tunnel vision to begin shortly and we're confident we will raise our rating soon. Perhaps even tomorrow."

Trying to place a value on the P/E ratio can be very difficult. Does value lie in recent earnings? Aren't cash flows more indicative of true value? How about a dynamic management team and brand name? Shouldn't the balance sheet carry more weight than earnings? It seems the perception of the market is being challenged as more and more investors and analysts raise these issues and question the current value of the P/E.

"Certainly, those who are hesitant to look beyond the P/E when considering an investment will miss out on a great deal of fantastic opportunities," added Wall Street Journal columnist and noted P/E bear Skip Freeman. "Becoming familiar with the limitations and appropriate employment of the ratio is a must for any well-armed investor."

While not everyone is in agreement, it appears the P/E ratio is indeed being scrutinized more than ever before as its valuation soars. This could mark a movement toward seeking value in quality businesses, emerging and important technologies, and sound cash management rather than trailing 12-month earnings. The P/E could very well have reached its market highs.

[Note: The names and characters in this column are purely fictional. Any similarity to those living or dead is purely coincidental. For a serious discussion of the value of the P/E, read yesterday's excellent column by George Runkle.]

-- Vince Hanks, TMF Elwood on the Fool discussion boards

Drip Portfolio

6/22/2000 Closing Numbers
Ticker Company Day Chg % Chg Price
CPBCAMPBELL SOUP-5/16-1.05%$29.50
INTCINTEL CORP-4 15/16-3.55%$134.06
JNJJOHNSON & JOHNSON-1 5/16-1.46%$88.56

  Day Week Month Year
To Date
Drip -2.07% 4.45% 1.87% 26.76% 64.68% 18.73%
S&P 500 -1.82% -.84% 2.22% -1.16% 54.69% 16.20%
S&P 500(DA) -1.82% -.84% 2.22% -1.16% 57.31% 16.88%
S&P 500(DCA) n/a n/a n/a n/a 26.17% 8.33%
NASDAQ -3.13% 1.98% 15.76% -3.26% 150.82% 37.24%

Trade Date # Shares Ticker Cost/Share Price LT % Val Chg

Trade Date # Shares Ticker Cost Value LT $ Val Ch
  Cash: $0.05  
  Total: $5,920.12  

• S&P 500 (DA) = dividend adjusted. Dividends have been added to the total return of the index.

Drip Port launched with $500 on July 28, 1997, adds $100 to invest every month, and the goal is to own $150,000 in stock by August of the year 2017. Due to the slow nature of dollar-cost-averaging and our relatively significant starting costs, we do not expect to seriously challenge the S&P 500 for the first three to five years as we build an investment base. The long-term advantages of dollar-cost-averaging still overcome the short-term disadvantages, however. Final note: our investment in Campbell Soup is frozen due to fees instituted in its investment plan. Click here for a history of all Drip Port transactions.