Fantasy Value Can Lead You Down the Wrong Path

If you like to buy companies on the cheap – like I do – you probably look at their P/Es. That’s fine. Just know what you’re looking at. If it’s a forward P/E, ignore it.

What’s a forward P/E? Let me explain.

Investors use P/E (price-to-earnings) ratios to measure how cheap a stock is. “Value” investors love P/Es below 10 – meaning the price of a share is less than 10 times earnings per share. Since P/Es vary from sector to sector, some value investors simply look for P/Es that are below the average in their sector.

A “Ratios” report is available on the Reuters website for every listed company, and is the easiest way to look this up. To its credit, Reuters uses only “P/E Ratio (TTM).” The TTM stands for “trailing twelve months.” Other financial sites – including Yahoo – also give “forward P/E.” This shows you what the company is expected to earn over the next year compared to its current price.

“Trailing” P/E and “forward” P/E seem like close cousins, but they differ in one key respect. Trailing P/E is a real number. It records what has happened. There’s no disputing it. On the other hand, forward P/E is just a guess. It’s Wall Street’s best estimate on what a company will earn in the future. By jacking up future earnings that haven’t yet occurred, analysts can make a company look much cheaper than it is. Right now, for example, some are projecting earnings to increase 70 percent this fourth quarter over last year’s fourth quarter. And the chances of that happening are next to nothing.

Forward P/E is least reliable when it’s based on an economy that no longer exits. At a time like this, when the economy is undergoing a major shift – from growth to recession – you don’t want to rely on analysts who are living in the past.