I don’t know why, but there is a surprising lack of coverage on why price/earnings as a comparison ratio is a terrible idea.
Yes, I know it’s convention. But frankly, that is the worst reason ever to continue with a status quo. “Sorry luv, I know you’re probably not a witch—as that’s not a real thing—but convention (and withered crops) means I have to drown you.”
When it comes to valuation metrics, we know two things to be true:
1. Price is always a positive number.
2. Earnings are not.
So, why do we divide the former by the latter? Instead of offering an intuitive means by which to assess different companies, it results in an assortment of "outliers" and "non-meaningful" results if earnings happen to be low, zero, or negative. For example:
How does General Dynamics look to you? Hard to tell, right?
A good visualization technique can paper over the cracks of a confused ratio choice:
But there is an alternative to a half-arsed solution. Flip the ratio and use earnings/price (otherwise known as earnings yield):
Now how does General Dynamics look? Here, by using E/P instead of P/E, it’s clearer how a company's valuation relates to its comparables. Instead of a higgledy-piggledy chart requiring some intense squinting to comprehend, you have a clean comparison of valuation.
Moreover, the position and order of the companies means it is easier to spot true outliers, not just companies that look weird due to the P/E convention. For example, in the final chart, it becomes clear that Aerovironment is not as strange as the first chart would have you believe—it just has low earnings right now—whereas AAR Corp's negative earnings yield draws greater inspection. Knowing this means you can have a deeper and more useful conversation with your clients about what that may mean.
So while convention may require you to continue with P/E in client meetings, it’s really E/P that will provide the clarity and comprehension needed to evaluate a company’s valuation.
Any thoughts on E/P instead of P/E? Let me know at email@example.com.
Want to improve your valuation metrics? Visit www.pellucid.com.