Price-to-earnings ratio (P/E) is a popular measurement of a company’s true worth. I’ve always liked companies with a P/E below 10. But nowadays, I pay little attention to this number – for two reasons, and both involve the earnings part of the ratio…
1. The economy is slipping so fast, past-performance P/Es shed little light on what is in store for the company right now. Many companies that did well 1-3 quarters ago are now finding it hard to grow earnings.
2. Forward P/Es are just as bad. They’ve always been based on analysts’ guesses of how much they think a company will earn the following year. But now those guesses – never reliable in the first place – are lagging badly behind what is happening in the real economy. For example, analysts still expect earnings in the tech sector to rise 21 percent next year. That simply won’t happen.
As an alternative, look at the price-to-book ratio (P/B). It measures a company’s share price relative to its net asset value (NAV). If that number is below 1, it means you’re paying less for the company than its assets are worth. And it means you’re getting the business of the company (not included in the NAV) for free. A P/B of less than 1 also helps put a floor under share prices, especially for companies that are still making a profit but are getting punished by a falling market.
Buying good value is not only a good way to pick companies in a falling economy, it’s the only way. And with earnings so unpredictable, P/B is a good alternative to P/E as a measure of value.
[Ed. Note: Finding strong companies with a P/B under 1 is a good way to prosper despite the market's condition. But you can also make money on companies that are ready to crumble. Learn how to spot the "red flag" signals that could predict (with as much as 92 percent certainty) when a company's stock is going to tank.]
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