P/E Ratios Still Matter

By Glenn Curtis | February 01, 2007 AAA

With the relative frothiness we've seen in the market over the last few months, it seems like every stock is making good money for investors these days.

But it's a simple fact that good ol' P/E ratios still matter.

Sure, I realize that some companies including Google (GOOG) continue to fare quite well in spite of their lofty P/E ratios.

But a closer look reveals that low P/E stocks continue to outperform higher P/E stocks.

As evidence, take a look at what's happened at a little company you might have heard of called Apple Computer (AAPL). In late January 2006 its stock was selling in the mid $70s and it sported a P/E ratio of more than 40 times trailing earnings. Pretty hefty!

Of course, some would argue that Apple's P/E at the time was justified, given that it wound up reporting a 46% year-over year earnings improvement in 2006.

However, a funny thing happened. In spite of its operational prowess and the fact that Apple delivered on the earnings front, its stock rose only about 11% during that same time.

Compare that to another well-known computer marker such as IBM (IBM). In late January 2006 it's stock was trading just north of $80 a share, and the company was trading at about 16 times trailing earnings.

During 2006, IBM reported earnings growth of 25%, which while impressive was well short of Apple's performance. So what happened to its stock? It's up just over 20% from a year ago, just about double Apple's percentage gain.

Is there anything special about IBM? Not particularly. It's had its share of ups and downs over the past year just as Apple has.

So what gives?

History suggests that over the last hundred years investors have, on average, paid about 14 times earnings for stocks they own. And while those same investors at times have deviated from this historical average, history also suggests that when P/E ratios become overextended, that the underlying stock (or index) will tend to suffer a period of underperformance as it trends back toward the mean.

In addition, when two like companies are compared side by side, everything else being equal, the company with the lower P/E will tend to outperform the company with the higher P/E. (For more depth on the nuts and bolts of the P/E ratio, check out Understanding The P/E Ratio.)

Need some additional evidence of the P/E to price relationship?

Check out the Johnson & Johnson (JNJ) vs. Merck (MRK) comparison. In late January 2006 Johnson & Johnson was trading just north of $56 a share and at a reasonable 16.52 times its trailing twelve month's (TTM) earnings. In 2006, it posted 11% year-over-year earnings growth. Not too shabby.

Meanwhile, in late January 2006, Merck was trading just above $33 a share, and at roughly 13 times trailing earnings -- a bit cheaper. How about it's earnings? In 2006, earnings were essentially flat from 2005 (however, given recent patent expirations those results were actually considered quite good).

What happened to the stock prices?

Johnson & Johnson's share price rose about 19%. Merck's rose about 33%.

Next, check out the McDonald's (MCD) vs. Yum! Brands (YUM) comparison. In late January 2006 McDonald's was trading at just over $34 a share, and at roughly 16.6 times trailing earnings. In 2006, it grew its earnings 39% over 2005's results.

Meanwhile Yum brands was trading just under $49 a share, and at 18.3 times trailing earnings. In 2006 it's expected to show a roughly 9% year-over-year earnings growth (its 2006 numbers haven't been released yet).

How have the stock prices fared?

Yum increased about 22%. McDonald's rose about 29%.

And you guys thought that P/Es went out of style when the internet revolution took hold. Ha!

The Bottom Line
Some will invariably argue that we are in a new era and that P/E ratios as a means of evaluation are simply a thing of the past. But given what I'm seeing, I would argue that they are as relevant as ever. Focus on the low P/E stocks and you've got a better shot at bagging market-beating returns.

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