The Truth About P/E Ratios and Book Values
For years, you've been told to look for stocks with low P/E ratios and low price-to-book-value ratios.
There's just one problem: An analysis of the performance histories of thousands of stocks proves that this advice is dead wrong!
Let's start with P/E ratios. An analysis of the stock market going back to 1953 found absolutely NO correlation between a stock's P/E ratio and its future price. Some stocks with low P/Es went up . but many others went down. And some stocks with high P/Es were among the most successful stocks in history!
The reason P/Es are such a lousy indicator is that they measure today's price in relation to yesterday's earnings.
Buying a stock based on P/E is like driving a car while looking in a rear view mirror. You can see where you've been, but you have no idea where you are going.!
Here's a better way to use P/E ratios: Compare the stock's P/E to its earnings growth.
Take Dell Computer, for example. Many investors think it's over-priced because it has a P/E of 72, which is 2.1 times the P/E of the S&P 500.
But while the companies in the S&P have an average earnings growth of 17% a year, Dell's earnings growth is a staggering 84%. In other words, its P/E is twice as hight as the S&P, but its earnings growth is five times as high! That makes the stock a bargain!
Now let's look at book value. Book value is a measurement of what a company would sell for if it had to quickly liquidate all its tangible assets. Tangible assets include real estate owned, equipment and machinery, vehicles, and product inventory.
During the old industrial era, book value was a great way to measure a company's worth. But as our economy moved more toward a service economy (and then an information economy) book value became more and more irrelevant.
Take Intel, for example. Sure, Intel owns factories and equipment. But the company's value comes not from its factories but from its intellectual property. It's the intellectual property that enables Intel to create the better, faster computer chips everybody buys.
Bottom line: Use book value as a measure only when you're analyzing companies that are in the real estate businesses . or bankrupt companies in liquidation. For all other companies, book value is 100% irrelevant!
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How Richard Schmidt Finds His Stellar Stocks
