The P/E ratio is often looked upon with disdain because of its deceitful nature. After all, who would want to use such a capricious number, forged from the bowels of corrupted earnings statements, and riddled with hidden expenses, subjective timing of revenue recognition, and the selective selling of assets? And with companies forced to follow the regime of FASB 123 (accounting for stock-based compensation), pro forma earnings have become popular again, which makes following free cash flow over net income still very Foolish.
While the P/E ratio gets a bad rap (although usually not so embellished as you see above), it doesn't mean investors should steer clear of using it. There is one factor in particular which makes it a very valuable tool for an investor's utility belt: It makes an decent proxy for measuring market sentiment in general, for a specific industry, or for an individual company.
Examining the relative value of broad market indices can highlight where undervalued stocks may be plentiful. The same ends can be achieved through various mutual funds as well. In his book Beating the Street, Peter Lynch describes a way of measuring the status of the emerging growth sector by calculating the ratio of the P/E of T. Rowe Price's New Horizons fund, which invests in small-cap growth companies, to the S&P 500's P/E. This chart reveals that the best time to buy small growth companies is when the ratio goes below 1.2. On the flip side, when it eclipses the 2.0 mark, a period of significant decline has always followed. The ratio is currently on the rise, but still well below the 2.0 threshold. In other words, bargains can still be discovered.
When you start looking at P/Es of specific companies, it becomes more useful to examine the overall P/E of the sector and industry it operates in, instead of comparing it with the market in general. For example, Shanda Interactive Entertainment (NASDAQ:SNDA) has a P/E of just less than 50, which is completely unreasonable when taken in comparison with the 18.11 of the S&P 500. However, it is a part of the technology sector, which has an average P/E of 39.5. Being a small-cap growth stock further contributes to the premium investors have to pay and provides some justification for the extremely high P/E. On the other hand, if a large-cap stock such as Intel (NASDAQ:INTC), also a member of the technology sector, had a P/E of 50, I would have no problem telling you to look elsewhere.
Finally, comparing the P/E of your favorite company to its competitors can be quite revealing. If you were interested in Wendy's (NYSE:WEN), you should try to figure out why it is trading at a premium of 32.2 when McDonald's (NYSE:MCD) and Yum! Brands (NYSE:YUM) have P/Es of 16.9 and 18.6, respectively.
No single number is going to tell you the whole story of a stock. Becoming a better investor requires learning which numbers work in certain situations. While the P/E can be deceptive when used in valuations, it is an excellent tool for quickly discovering what the majority of investors think about a company and whether the stock is worth a closer look.
Shanda Interactive Entertainment is a Motley Fool Rule Breakers recommendation.
Fool contributor John Bluis does not have shares of any of the stocks mentioned in this article. The Motley Fool has an ironclad disclosure policy.
