Ultimately, investing involves buying something for less than it's truly worth. Figuring out how much something is worth is easier said than done. For a stock, investors need to weigh current financial performance, the quality of the balance sheet, future growth prospects, macroeconomic conditions, and a host of other factors.
The price-to-earnings (P/E) ratio is a shortcut. Take the stock price and divide it by earnings per share, and you get a number that tells you how expensive a stock is based on current profits. Historically, the S&P 500 has averaged a P/E ratio around 16.
This obviously doesn't work well for growth stocks with scant earnings, but it can be useful for mature, somewhat predictable companies. If you assume that earnings are sustainable, the lower the price, the lower the P/E ratio, and the cheaper the stock.
A flawed assumption
That assumption, that earnings are sustainable, will get you into all sorts of trouble if you apply it to the wrong kind of company. Cryptocurrency exchange Coinbase (COIN -5.10%) is a great example of a case where the P/E ratio should absolutely not be used to value the stock.
Coinbase made a lot of money in 2021 as crypto investors and speculators piled into Bitcoin and other digital assets. Most of Coinbase's revenue comes from transaction fees, and with the promise of massive profits fueling demand for crypto, transaction volumes soared. Coinbase reported $7.4 billion of revenue and $3.6 billion in net income for last year, with both figures up astronomically from 2020.
Coinbase stock was a different story. After peaking in late 2021, shares of Coinbase began to tumble. By the time the company reported its mesmerizing fourth-quarter results in February, its stock price had been roughly cut in half from its all-time high. Based on its 2021 earnings, Coinbase's P/E ratio was less than 11 at the time of its report.
But Coinbase was not cheap. The thing about the P/E ratio that people sometimes forget is that the "E" can decline, or even vanish entirely. You could have looked at Coinbase in February and said: "Well, even if Coinbase's growth slows way down, the stock trades at a big discount to the overall market." But slowing growth was not the worst-case scenario. The worst-case scenario is what's playing out right now.
The prices of Bitcoin and other cryptocurrencies have crashed; the Terra ecosystem has imploded, wiping out tens of billions of dollars in market value; and Celsius Network has paused withdrawals. All of this adds up to rapidly eroding trust in cryptocurrencies, along with much lower trading activity.
Coinbase's revenue in the first quarter of 2022 was down more than 50% from the fourth quarter of 2021, and net income plunged to a loss of $430 million. Just like that, the stock went from ostensibly cheap based on the P/E ratio to having no P/E ratio at all.
More problems
It gets even worse. Coinbase rival Binance.US announced on Wednesday that it will offer Bitcoin trading without fees, and that it plans to remove transaction fees for other cryptocurrencies in the future. With the rampant speculation of the past couple of years cooling, cryptocurrency exchanges now must compete for users just like online stockbrokers.
Coinbase's golden goose of excessive transaction fees is going to go away sooner or later. The company offers services that generate some revenue, but demand for many of those services is still dependent on interest in cryptocurrencies.
Shares of Coinbase have fallen further this year -- the company is now valued at less than $12 billion. That may still not adequately reflect the risks involved. Revenue will likely fall off a cliff this year, and profits are a thing of the past for now. Competitors are trying to steal away users with no fees, and Coinbase is aggressively cutting costs and laying off employees. If there's a bull case for Coinbase, I'm not seeing it.
Coinbase looked cheap earlier this year as the stock plunged, but its profits soon followed suit and rendered traditional valuation metrics meaningless. Coinbase is a prime example of why successful investing can't be boiled down to simple ratios.
