by Stephen Diamond
On Monday, David Gaffen had a very timely post in The Wall Street Journal’s Marketbeat Blog on the illusory nature of currently low price-to-earnings ratios, which may have been lost amidst all the clatter of the day’s Spitzkrieg.
The conventional wisdom, as echoed by many financial advisors and business pundits, is that P/E ratios are currently low and present an attractive buying opportunity. But as Gaffen suggests, potential buyers should be wary of such surface level analysis, for it rests on the precarious assumption that trailing twelve month profit levels will remain constant, or grow, over the next several years. If that assumption is correct and they do, then current P/E ratios indeed are low.
But how likely are profits to grow or even stay constant in an economy experiencing rising inflation, soaring oil and other commodity prices, a shrinking job base, falling home prices, high consumer debt levels, and rising mortgage defaults? Answer: I wouldn’t bet on it.
If profits of public companies fall, P/E ratios at best will rise; more likely, they will rise briefly, then drop to current multiples as declining share prices offset the drop in net income. Unless, of course, an investor bought those shares at current price levels, in which case, the P/E ratios would be much higher and the investor would be in the hole.
The Take-Away. Investors tempted to buy stocks based on relatively attractive P/E ratios in the current market environment should remember that these multiples are historical and proceed accordingly. Or, to paraphrase the words of Hill Street’s Sgt. Phil Esterhaus, “let’s P/E careful out there.”
