To many investors, the price-earnings ratio is the single most indispensable indicator for any stock purchase. Sadly, they are putting their trust in a myth.
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Surely, the P-E ratio is the most common way to gauge a stock's valuation, i.e., how its share price compares with the company's earnings. Usually, the share price is divided by the trailing 12 months of earnings per share. The idea is that the lower the ratio, the more attractive the stock is.
The ideal P-E ratio can vary, but many investors look for stocks with P-E ratios equal or lower than the S&P 500's. This and other valuation methods are required reading for equity analysts and are treated in finance courses as accepted doctrine.
But here's the rub: Decades of market research finds that winning stocks tend to have P-E ratios that value investors consider too expensive — even at the start of their giant price runs.
As long as a stock has superior fundamentals, institutional support and other traits of market winners, the valuation doesn't really matter. Google parent Alphabet (GOOGL) famously reached a P-E ratio in the 50s and 60s while its share price went from 115 in September 2004 to 475 in January 2006.
The Folly Of Price-Earnings Ratios
The folly of P-E ratios was discovered when IBD founder and Chairman William O'Neil conducted research on what exactly caused stocks to explode in price. Strong earnings growth, especially in the two most recent quarters, was a key factor shared by these winners. But the P-E was usually well beyond acceptable levels when stocks began their big price advances. In fact, P-Es get even higher as the advance gains strength.
High P-E ratios, O'Neil explained in "How to Make Money in Stocks," are a result of accelerating earnings growth, which itself is what attracts institutional investors to stocks and causes share prices to soar.
Other Examples Of P-E Ratios
Since then, there have been many more examples of how successful stocks have defied the norms of price-earnings expectations.
Veeva Systems (VEEV) topped a 28.05 buy point in May of 2016. The cloud-based software maker for the life sciences at that time had a lofty P-E ratio of 51. Veeva continued to climb, thanks largely to a strong earnings report in late May that year that pushed the stock to 52-week highs.
In November 2016, when Veeva broke out past a 42.68 buy point in an 11-week flat base, the P-E ratio was 63. By April 2017, shares were trading above 50.
New issue Planet Fitness (PLNT) broke out of a large cup with handle in July 2016. At the time, the price-earnings ratio was 58. It didn't matter. The chain of gyms rose nearly 19% from the 17.35 buy point until it started a new base.
This article originally was published April 5, 2017 and was updated.
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