Why the Price-Earnings Ratio is a Hoax

Tesla Spotlights 
Curse and Cure

According to a rampant hoax, the ratio of price to earnings (PE) is the mainstay for gauging a stock for investment. The yardstick is meant to divine the likely direction and extent of the price level downstream.

Unfortunately, the PE ratio can and often does vary hugely from one stock to another whatever their future prospects might be. Moreover, the quotient has a way of swinging wildly over time even for a given equity. As a result, the PE metric is hereby exposed as a treacherous guide to predicting the market. 

According to the party line, a high value of PE implies that the stock is overpriced and will thus crumple before long. In reality, though, the quotient can remain lofty for ages or even climb higher. 

From a different angle, the PE quotient tends to rise with the likely rate of growth in future earnings. For this reason, the PE ratio relative to the growth rate is a much better yardstick for vetting a stock. 

That is, the PE ratio may be divided by the growth rate, G. The latter term denotes the estimate of growth in earnings on an annual basis, expressed as a percentage of the profits actually garnered over the previous 12 months. The resulting quotient is known as the PEG yardstick.

The PEG is far more consistent than the PE throughout the stock market. As a consequence, an extreme level of PEG goes a long way in gauging whether a stock is overpriced, underpriced, or moderate.

Despite this fact of life, the mass of participants – ranging from part-time amateurs to full-time professionals – believe the PE ratio to be the mainstay for valuation. As we noted earlier, though, the PE varies a great deal regardless of future prospects and is therefore pretty much useless for sizing up a stock. Instead, the PEG yardstick provides a better metric by far in gauging the zest for the widget among market participants.

On a positive note, investors in the aggregate seem to grasp the bunkum behind the PE ratio on a subconscious plane even as they affirm its primacy at a conscious level. Here is an example where people say one thing, but do something else.

To round up, investors are impulsive creatures that like to band together. For instance, the plungers pile into the ring in the heat of a bubble and flee en masse in the freeze of a panic. One upshot is a wild ride in the ratio of the current price to past earnings. For this and other reasons, the PE is a lousy guide to valuation. On the bright side, though, the punters are far more consistent when the PE is adjusted by the future growth of earnings. 

Here is a rare instance where the actors as a group do the sensible thing despite their faulty grasp of the marketplace. Whether or not a gamer believes in the fable of the PE, they must act according to the PEG in order to prevail. Otherwise they suffer the consequences and often pay dearly as a result. 

In short, the shrewd investor in order to survive and prosper has to pursue a cogent strategy in practice even if they embrace the myth of the PE from a conceptual slant. In reality, the PEG is a far better gauge for divining the current appeal and future promise of all manner of stocks.

NOTE:  The full report is titled, “Why the Price-Earnings Ratio is a Hoax”. The document in PDF form is available at ResearchGate

#Investment #Tesla #Stocks #Growth #Hoax #Myths

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