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An interesting story in Forbes today got my wheels turning about the P/E ratio and other valuation metrics.  Long time readers know that I hate P/E ratios.  In fact, I hate most valuation metrics.  An asset is only worth what you can sell it for today.   It doesn’t matter whether it sold for $X in 1970 or $Z in 2008.  The only price that matters is today’s price (assuming you’re actually a buyer and/or seller of said asset).  Value is in the eye of the beholder.

The problem with most valuation metrics is that they’re based on moving past data or estimates (guesses is really more appropriate).  For instance, on one side of the P/E ratio you have an E that is either: 1.  based on a rear view mirror trailing figure or 2. based on the assumptions of a group of clueless analysts (depending on whether you favor the trailing or forward PE).   The trailing PE has to be immediately defenestrated.  Past data is simply not useful in gauging most future stock market performance.   No two future markets are alike despite Wall Street’s intense attempts to try to compare this bear to that bear….Besides, stocks can remain cheap longer than you can remain solvent as most value investors found out last year.  The forward PE seems much more logical, but it’s based on a bunch of guesses by so called experts.  Regular readers have seen me debunk wall street analysts in real-time on multiple occasions.   Analysts are notoriously poor at guessing future earnings so why do so many rely on them for 50% of the forward PE equation?

The author of the article likes to compare 10 year treasuries to stocks.  Good point, but how did such a valuation metric work out for investors in Japan who have seen sub 1% yields for two decades?  Stocks have looked cheap in Japan for 20 years if you compare them to bonds.

This is why I prefer to use valuation metrics like my Expectation Ratio and/or sentiment readings.  These not only take the actual real life earnings into account, but compare those actual earnings to the current expectations.  You can have a stock valued at a PE of 100 and as long as it continues to outperform the estimates the likelihood is that that asset will continue to appreciate (this is generally what causes bubbles).   You can also have a stock such as TOL which sells at a very low multiple in 2005 (due to high growth and high estimates) which ends up selling at an even higher valuation in 2009 after a 75% haircut.

Furthermore, PE ratio lovers and value investors have been slaughtered in the last two years.  The major flaw in buying low PE stocks is that you need to be buying them in a market that is actually appreciating going forward.  I am a firm believer that a rising tide lifts all boats.  Go out and buy the worst stock on the planet and if we enter a raging bull over the next 10 years your “cheap” stock will perform very well.  On the other hand, if the market does poorly, the likelihood is that your “cheap” stock will get cheaper.   There are a lot of investment “gurus” out there who simply owned high beta names  or “value” stocks during the 80’s and 90’s who looked like geniuses.  Fortunately for them, even the  turd in the bathroom goes up when the plane takes off, unfortunately, when the plane crashes back to earth the turd falls with it….