Today, The Wall Street Journal reports on the "Decline of the P/E Ratio", first discussing the reason for the dropping P/E of the overall market (uncertainty) but more importantly, why the P/E is no longer as prominent as it once was. I take exception to the argument that the P/E ratio is no longer relevant and I think the article proves my point. The Journal states that:
"With profit and economic forecasts becoming less reliable, investors are focusing more on global economic events as they make trading decisions, parsing everything from Japanese government-debt statistics to shipping patterns in the Baltic region."
While this trading mentality will no doubt affect short-term prices, the long-term determinant of stock prices remains the earnings that a company can generate. When a company generates earnings over the long-term, it can raise its dividend and it will be a more worthwhile investment.
How do Japanese government debt stats and shipping patterns in the Baltic region affect stock prices over the long-term? They really don't. While markets are becoming more globally-oriented by the day, there is little to no benefit in that information for long-term investors. While short-term investors may be able to exploit such data by trading on that news, the cost of doing so and the lack of expertise most people have in such areas will quickly erase any advantage the trader thinks he has. On the reverse, the long-term investor should be concerned with one thing and one thing only: earnings.
The P/E ratio can be either forward looking (forward P/E based on earnings estimates) or historical (trailing P/E based on EPS in the last 12 months), it holds a wealth of information. After all, with one figure, we are able to gauge both what the market expects a company to earn in the future and how much its willing to pay for $1 of earnings. For example, if XYZ Corp. is trading at a forward P/E of 22, then investors are willing to pay 22x for $1 of XYZ's earnings. Naturally, faster growing companies will have higher P/E ratios than slower growth ones.
The P/E ratio is far from dead. In the end, earnings matter. The P/E ratio is not a means to an end, but it's a good road map because it bridges the gap between a stock's price and earnings expectations based on each trading day.