Price-Earnings Ratios: The Pros and the Cons [by David Lehman]

In my experience, price-earnings (PE) ratios are the most efecvtive way to evaluate common stocks. Here's an oversimplification for the beginner. The price of a stock is what it's listed for on the Big Board or Nasdaq or whatever stock exchange you choose. The number varies from minute to minute -- actually from nano-second to nano-second -- simply because the market arrives at the figure by the oldest economic model, that of supply and demand. The former (the number of shares available for purchase on any given day) can fluctuate, but is the latter -- the demand for a stock -- that can gyrate dizzily, for it depends on a whole range of factors, starting with earnings reports, continuing with rumors, modified or accelerated by news particular to the company, macroeconomic trends, or world events, and ending with the most volatile factors of all, investor sentiment and mass psychology. The earnings of a stock are the company's profits for the most recent three-month period divided by the number of shares outstanding. This, too, is an unstable figure. If the profit line rises, relative to the same quarter one year ago, then the price-earnings ratio should narrow, making it a more attactive stock to buy, unless the price has already gone up in anticipation of this blessed event.

Even this brief summary shows the difficulty of using P-E ratios. In addition to the instability of the figures, there are further variables you need to adjust for. There are industry-specific factors: for example, historically a blue-chip bank would have a lower P-E ratio than a manufacturer of electronic equipment. But the history of bank stocks since the collapse of my Fictional Uncles' investment house on September 15, 2008, refutes even the loose application of P-E theory that suggests that a low ratio correlates to a relatively safe investment. Then there are "earnings surprises" -- spikes or drops in profit -- that have an immediate effect on the price of a stock, and that no P-E ratio, however sophisticated your calculations, will prepare you for. Let Burton G. Malkiel, author of A Random Walk Down Wall Street, a real pro and no con, have the last word: "God Almighty does not know the proper price-earnings multiple for a common stock."

This is the segue I needed to justify tagging the previous post -- "All God's Chillun Got Rhythm," as sung by Ivie Anderson (and also as performed in the Marx Brothers' Day at the Races) -- in the category of  "Financial Market Report." Faith in the Lord is the single best guarantor of good stock market perofrmance especially if expressed with the hassidic abandon of the singers and dancers of "All God's Chillun Got Rhythm." You can read about the song here, with special reference to the scene in the Marx Broithers movie. For a discussion of the song as a jazz standard, click here. Did you know that Gus Kahn ("Love Me or Leave Me," "I'm Through with Love") wrote the lyric? Happy new year! -- DL 

  

Comments

[Laura Orem]

Finance makes my head hurt. Ivie Anderson's voice makes my heart sing. :)

[labour hire]

Same here, it's giving me a headache..