6 Pitfalls Of Using Price/Earning Ratios

July 08, 2014

Multiples don’t all work over the short term, and they can be skewed to suit your view.

[This article previously appeared on our sister site, Europe.ETF.com.]

Stock pickers and indexers use their own metrics and valuation multiples to classify stocks, determine their share price and decide whether they are over or undervalued by the market.

These multiples – whether it be cyclically adjusted price to earnings ratio (CAPE) or otherwise – are proven to be poor indicators of short term performance, meaning they are better used when making long term decisions. Some long term indicators do not work well either.

Legal & General Investment Management’s equity strategist Lars Kreckel gives investors six pointers about the value and pitfalls of using multiples to assess equities, what factors we should look at and whether indicators tell us equities look cheap or expensive at the moment.

“It does make it surprising how much valuations are mentioned in conversations, even among sophisticated investors,” he said. “They say European equities are overvalued so you should be underweight. That’s a bogus argument.”

Here’s why:

1) Don’t be afraid of index highs

Equities are at all-time highs and that makes people nervous. But investors should remember this is business as usual, and equities should go up over time. Also bear in mind that our perception of this is warped by our experience over last 15 to 20 years: equities have not made many all-time highs, and they have not lasted long. Just think of the tech bubble and ensuing rally, then the financial crisis and the subsequent rally. And don’t get too hung up on individual index levels. It is arbitrary as to how they are calculated and there are many ways to go about it.

2) Price is what you pay and value is what you get

Price itself doesn’t tell you anything about whether it’s a good or bad deal; [$7,350] sounds like a lot of money, but if you get a Porsche for that, it’s a bargain.

3) Valuation multiples are not great at predicting short-term returns

Unfortunately most investors are not focused on ten year returns and are more concerned about the one year horizon. The problem is if you buy a stock with a high or low PE, it tells you almost nothing your expected returns in one or two years' time.



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