Why ETF Price/Earnings Ratios Lie

August 28, 2014

Be careful when making fruit-basket comparisons; you’re likely to come up with lemons.

Last week, one of my analysts, Boris Valentinov, penned a blog titled “Brace For Irrational Exuberance 2.0.” In it, he looked at the price-to-earnings ratios of various ETFs, noting in particular that the iShares Russell 2000 ETF (IWM | A-79) had a surprisingly high P/E of 83. He went on to explain that the ratios get high because some of the companies in the index are actually losing money, and that somewhat paradoxically has the effect of raising the portfolio P/E.

The email traffic we received for the article wasn’t particularly kind. Most of it fell into one category: “You’re an idiot. IWM’s P/E is 28, so your entire argument is invalid and how can I ever trust anything you guys say ever again?”

So I felt it worth going into all the reasons people have fallen in love with P/E ratios, and why they’re almost always wrong, especially when you’re comparing ETFs.

First, why do we even look at P/E ratios? Back in the day, when people focused mostly on single stocks, price-to-earnings was the go-to measurement of growth. The theory was that if you were buying a stock to receive a future dividend stream, that dividend stream would have to come from earnings.

If you could buy a lot of earnings for not so much money, you had a better chance of continuing to get that dividend stream in the future. So, low P/E stocks were seen as “safe,” while high P/E stocks were seen as speculative.

The dirty little secret of investing—well one of them—is that of course these kinds of shorthand metrics are massive oversimplifications. JPMorgan Chase and China Fruits Corp. each have a P/E of 10, but the prospects for a $5 million fruit beverage company that sells in China and a quarter of a $1 trillion global financial company are hardly related. Still, if you’re trying to separate out different baskets of stocks for further analysis, P/E is a convenient first place to start.

The biggest problem (aside from the fruit versus bank problem) is accounting. Earnings are far from a pure, or even accurate, representation of what’s really going on in a company.

Companies regularly manipulate their reported earnings numbers through all sorts of shenanigans, whether it’s the rash of manufactured goodwill and bartered income that confused investors in the ’90s, or the magical disappearance of toxic assets from bank earnings statements following the Rule 157 changes coming out of the financial crisis. Earnings itself is a polluted number.

But it gets even more complicated when you start working with portfolios of stocks, instead of individual companies.

 

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