P/E to Determine Value – HOGWASH!

November 8, 2011 11:01 am

As we see it, until the European situation is under control there will continue to be large swings and volatility will be common. Don’t even try to find reasons for a quick rise or fall  during the day. News flow is strong and the media no longer feels that it is necessary to qualify any of the information that is sent to them before the broadcast it as fact.

During time such as these, it may be beneficial to get back to basics and look at what has worked and what has not. It is also a good idea to step back and look at the bigger picture in order to assess the investment landscape and opportunities that may become available.

Even as U.S. companies are doing well and their balance sheets are looking good, remember that everything was peachy toward the end of 2007 as well. We all know what happened next. So, it is not simply the health of  companies that provides for the market’s movement. Rather, it is a collection of influences that come together and alter sentiment. The very notion that “stocks are cheap or expensive” relative to their P/E ratio is preposterous. If it were that easy, why would anyone need to look past that one ratio to determine when to invest.

The reality is that the P/E ratio for the S&P 500 is a moving target and aside from earnings, it is impacted by sentiment, company potential and economic variables. So, the next time that you hear some blowhard opining about their market outlook based on the P/E ratio – disregard everything they say after that.

Granted, some stocks may actually be “cheap” and some “expensive”  although that will depend on what happens over time with their sale and earnings – keeping in mind that competition, market trend and other items will all play a role. For example, if the Asian markets continue to thrive and Europe manages to pull through, then perhaps there are some energy companies that will benefit. Or if the employment situation worsens, some consumer discretionary stocks could sink.

But, of all of the reasons to buy or sell, the P/E is the very last on our list. Instead, we prefer to look for companies that have been performing well in the current market conditions and have a steady growth of earnings and high ROE. Low debt to equity ratios are generally a positive and a global presence is beneficial. Of course there are several other measure that we use in the QuantaTechnaFunda (QFT) process, but suffice it to say that one simple ratio does not tell the whole story. (See some examples of stocks and the QFT scores HERE)

Beyond the analysis of a stock, the trend/direction of equity markets are a good barometer of sentiment and should be respected. This is especially true these days as the correlation of directional movement for individual names to markets are extremely high.

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