The price-to-earnings (P/E) ratio is among the most popular valuation multiples, and perhaps the most important for investors, but it has limited explanatory value when earnings per share are volatile.
Profits are a measurement of success over the long term, allowing a company to invest in further growth or return cash to shareholders. Intrinsic valuation methods championed by investors such as Warren Buffett and Benjamin Graham base share prices on the predicted future profits and cash flows of the underlying company. Thus, a metric relating stock prices to corporate profits can be powerful, but the current market and economic conditions are complicating P/E ratios.
Limitations of the P/E ratio
Using P/E is not always straightforward. Obviously, it is only applicable to companies that have earnings. It can also present problems for businesses with volatile results, as is the case with cyclical industries such as homebuilding, hospitality, semiconductors, and materials. This issue becomes especially relevant under the current circumstances, in which many businesses are experiencing temporary shocks caused by the coronavirus. Distorted results in the second and third quarters of this year, as well as an uncertain outlook for 2021, cause trailing and forward P/E to be misleading for many stocks.
Southwest Airlines demonstrates that a high P/E is not necessarily a red flag. Image Source: Southwest Airlines.
Struggling companies look deceptively expensive
Consider the case of Southwest Airlines (LUV 2.57%). Air travel in the U.S. fell drastically in the second quarter of 2020. Even with traffic ticking back up in the second half of the year and more optimism around 2021, the short-term outlook is still grim. Surveys show that consumers are reluctant to brave crowds for social activities like flying, and high unemployment may hurt demand for travel into next year as discretionary income falls.
After Southwest delivered earnings per share of $4.27 in 2019, analysts are forecasting substantial net losses for full year 2020 and modest profits next year. As a result, Southwest trades at 109 times trailing earnings and over 27 times forward earnings estimates, which are high for airlines compared with historical averages. Sophisticated investors are thinking about the cash flows that the business can generate beyond 2021, and profits are likely to return to normal levels if the airline can survive the coronavirus shock. P/E ratios are therefore uninformative, and the stock might not actually be so expensive under more-nuanced analysis.
Some cheap valuations are too good to be true
This same effect can work in the opposite direction. Companies such as Campbell Soup (CPB +2.20%) and B&G Foods (BGS 3.80%) are benefiting from the rising proportion of meals cooked at home rather than eaten at restaurants. Campbell delivered $2.95 in adjusted earnings per share in fiscal 2020 (which ended Aug. 2, 2020) and is expected to see a small decline in fiscal 2021 as people begin eating more meals at reopened restaurants.
B&G is expected to deliver earnings of $2.19 per share in its fiscal 2020, compared to $1.64 in 2019 and a forecast of $1.96 in 2021.
The temporary earnings pop in both cases leads to deceptive P/E ratios. In the current market, Campbell appears cheap at 16 times forward earnings, as does B&G at 14 times. However, these figures do not necessarily indicate there is an opportunity for investors that the market has overlooked but rather the acknowledgment that results are likely to normalize in 2021 and beyond.
In lieu of P/E, investors can focus on other metrics such as dividend yield, price-to-book value, or price to sales. Corporate management is less likely to drastically alter dividends if results are only temporarily distorted, so this could provide a more reliable read on longer-term conditions. Unfortunately, other popular valuation ratios such as price to free cash flow, or enterprise value to EBITDA, may be temporarily undermined by the same forces impacting P/E.
More sophisticated investors who believe in the validity of intrinsic valuation can try discounted cash flows (DCF), dividend discount, or residual earnings methods to relate share prices to cash flows further in the future. Finally, there are some companies with operations that have not been drastically altered by the coronavirus. These may still be appropriate candidates for P/E analysis, but investors should be careful in its application.
