How to use stock ratios to predict the future

If you have even the slightest interest in investing, there's one number that you're almost certain to have encountered: the price/earnings (p/e) ratio. It's little wonder it's so widely quoted it's easy to calculate and it seems to offer the Holy Grail of investing: a single number that reveals whether a share is cheap or expensive. But be careful. While the p/e can be useful, used in isolation it can lead you to make bad investment decisions. Here's why, and what you can do about it.

The recipe

"Pick a stock. Divide the current year's estimated earnings [per share] into the stock price. Out pops a number. Is the ratio anywhere near single digits? It's a buy. Good times!" That's p/e investing in a nutshell, according to the Lex column in the Financial Times. So if a company has a share price of £3 and estimated earnings per share (one year's forecast earnings divided by the number of shares in issue) of 50p, the p/e is six (£3/50p). If the sector average p/e is ten, then the stock is cheap.

Put another way, if we assume zero interest rates, the firm on a p/e of six will repay your initial investment in about six years, whereas its sector peers will take ten years. A sound buy' signal then? Sadly, no.

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Simple isn't always best

There are several traps here. Firstly, a current' p/e ratio (an alternative is a historic' p/e using the last 12 months' reported earnings, but this is immediately out of date) relies on an earnings estimate. Analysts are notoriously bad at getting these forecasts right. As my colleague Phil Oakley puts it: "Companies themselves, with all their information about customers, sales and costs, can't really predict how much money they will make in the future, so what chance does an external analyst have?"

Secondly, even if you could guarantee an accurate estimate, the earnings figure may be misleading on two other counts. Earnings figures can be an unreliable guide to a firm's cash flows the building block for a reliable company valuation. That's partly because the number is stated after various subjective costs, such as depreciation and amortisation (annual charges that are supposed to match the cost of long-term assets, such as plant and machinery, to the revenue they generate).

Earnings can also fluctuate year on year. So taking a single year's snapshot estimate as a reliable guide to a firm's true earnings over a typical business cycle may be misleading. As Lex points out, in mid-2009 the p/e of the S&P 500 index (the US benchmark index) was over 20, the highest level in half a decade. But that was because profit margins had hit ten-year lows. They were set to bounce as firms cut costs. Anyone who ran scared of the high p/e missed a "monster rally" as the e' side of the equation surged.

Now the market trades at about 12 times forward earnings estimates. That's superficially much cheaper. But investors should note that "margins for S&P 500 companies hit a five-year high in the third quarter of last year and sales growth, which drives margins, slowed in the second half of 2011 after accelerating for six consecutive quarters".

So, while the market may boast a relatively low p/e, it doesn't mean it is cheap. The e' side of the equation may well be about to fall. This means that if you rely solely on a p/e to judge when to buy, you will often miss the boat (when profit margins are expanding), or overpay (when margins are contracting). So what should you do?

Some solutions

Various attempts have been made to improve on the p/e ratio. For the wider market, a better bet than a standard p/e is the cyclically adjusted price/earnings ratio (or CAPE). Devised by Yale professor Robert Shiller, it compares the current value of an index such as the S&P 500 to an average (inflation-adjusted) earnings figure for the market over the last ten years (roughly one business cycle). This smooths out the impact of any individual annual spikes or troughs in profit.

On this basis, the S&P 500 looks less enticing than its single year p/e suggests, on a CAPE of around 23 (compared to a long-term average of about 16).

When it comes to individual companies, some commentators, such as MoneyWeek's Paul Hill, replace the p/e with a ratio that is based more closely on a firm's cash flows rather than purely on its earnings. The enterprise value (EV) to earnings before interest, tax, depreciation and amortisation ratio (EBITDA), for example, expresses a firm's total market value in debt and equity terms (the EV) as a multiple of earnings before subjective charges for long-term assets (depreciation and amortisation) are taken out (EBITDA). However, firms are not forced to publish this number so you'll have to hunt around in the accounts to calculate it.

In any case, you should never rely on one ratio alone, however lauded it is by its fans cross check the p/e against other key valuation ratios. Sometimes you will be forced to do this because the p/e ratio won't give you a reliable answer.

For example, in fast-growing sectors such as technology, you may be trying to compare firms that have little or no earnings at all (and so the p/e ratio won't return a meaningful number). Here you are better off using a ratio such as the price-to-sales ratio (the firm's market capitalisation as a multiple of one year's sales). While sales can never fully replace earnings plenty of firms that make decent sales end up going bust the sales figure is less prone to fluctuate as wildly and is also less easy to manipulate.

Meanwhile, someone looking at firms in an asset-intensive sector such as property firms or investment trusts will usually be better off using an asset-based ratio such as price-to-book (p/b). In summary, when it comes to ratios the shoe needs to fit the foot.See my video guide to some other ratios that are well worth knowing.