More Dangerous Growth

Bigger is better. Growth is good.

Yesterday, we took a look at the above truisms in the context of the venerable PEG ratio. Today, we're going to look at the other half of the equation: the P/E. Or more specifically, the "E."

In his Investment Fables class, Professor Aswath Damodaran of the Stern School of Business at New York University explains the risks inherent in "choosing an 'E.'"

He writes, "The biggest problem with P/E ratios is the variations on earnings per share used in computing the multiple. The most common measure of the P/E ratio divides the current price by the earnings per share in the most recent financial year. ... Other people prefer to ... add up the earnings per share ion each of the last four quarters. ... Some analysts go even further and use expected earnings per share in the next financial year."

If you ever wondered why different websites give you different P/Es for the same company, then congratulations -- you've found the root of the problem. As I type this column, the markets are closed, and the stock price of Microsoft (NASDAQ:MSFT) is static. Yet Google Finance tells me the stock trades for an 18.87 P/E; Yahoo! Finance says, no, it's 18.40; and Microsoft's own MSN Money comes up with 18.90. One number is the "current P/E," the next is "trailing," and the third is anybody's guess.

Granted, these kinds of contradictions are more a nuisance than a danger to your portfolio. But hold on a second, I'm getting to the dangerous part. The trouble comes when investors don't like what they see in a company's current or trailing earnings, and instead choose to calculate a "forward P/E" -- the "expected earnings per share in the next financial year" that Damodaran speaks of.

A hypothetical based on a hypothetical
Deciding that a stock is fairly priced by assuming an unrealistic and analyst-hyped growth rate is dangerous enough. But you can compound the danger by compounding your assumptions, because analyst estimates of future growth are just that: Estimates. Assumptions. Guesses.

You see, your standard PEG ratio is at least partially based on fact. The "P" is fact. It's the price you see quoted today. The "E" has already happened, so that number is trustworthy (it's last year's recorded earnings, or the most recent four quarters' worth of earnings, so you can't really argue with it).

But if instead of basing your "E" on facts, you use an "E" that an analyst has postulated for next year's earnings, then your PEG ratio is constructed from just one fact (the price) and two guesses (the analyst's guess as to what next year's earnings will be, and the analyst's guess as to how fast the company will grow during the next five years.) Thus, you're calculating your PEG by taking a hypothetical P/E and dividing it by a hypothetical G.

If you still don't think this is a problem, let's go to the videotape. Actually, let's look at a few statistics for several companies in the cyclical video gaming industry, where growth has gone missing this year. It is, however, expected to skyrocket next year as Microsoft and Sony (NYSE:SNE) bring their new gaming consoles online.

Now look at how these companies' PEGs work out when based mostly on facts (trailing P/Es), as opposed to mostly on fiction (forward P/Es):

Analyst estimates -- flawed and overoptimistic as they might be -- at least take today's earnings numbers and extrapolate out how fast earnings might grow from a factual starting point. Based on those numbers, a value investor has to be leery of investing in any of the above companies at today's prices. Compound your hypotheses, however, and almost anything can start to look like a "buy."

Don't guess. Assess.
As harsh as the above assessment might seem on the surface, I really don't mean to knock any of these companies. On the contrary, at the Fool's flagship newsletter, Motley Fool Stock Advisor, we have actually recommended both Activision and Electronic Arts on multiple occasions over the years. We like the companies and we like their prospects enormously.

All I'm trying to do today is make you more aware of the hazards of wishful thinking and relying too heavily on Wall Street guesswork when valuing your investments. Leave the pros to their guesswork. In your own investing, do what we do at Stock Advisor:

• Estimate reasonable rates of growth.
• Demand reasonable prices, giving yourself a wide margin of safety.
• And always, always do your due diligence before investing. There's a reason we picked Activision and Electronic Arts for our portfolio, after all. And it has little to do with the companies' PEG ratios.

Want to learn why we originally picked, and still like, Activision and Electronic Arts? You can read our full write-ups on each, and on the 98 other recommendations we've made over the last four years, free of charge. All you have to do is take a free 30-day trial of Stock Advisor. Click here to get started.

Fool contributor Rich Smith does not own shares of any companies named above. If he did, he'd have to tell you so. Fool's honor. Microsoft is an Inside Value recommendation.