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Analysts point the finger at P/E ratios

Stock prices are driven by what you and I and a few million other people collectively expect the stock price to be. If we all think the price of Netflix is going to go up, we buy Netflix and — voila — that drives the price up. If Netflix reports bad news, we become instantaneously pessimistic and sell our Netflix shares. Subsequently, the price goes down. Underlying all of that is some implicit analysis of the present value of future cash flows, but only conceptually.

Many financial experts attempt to explain the price of a stock at any given time as an outcome of certain financial ratios. The most common is the P/E (price-to-earnings) ratio. This is simply a calculation of the current stock price (price per share) divided by the earnings per share (EPS).

In a perfect and orderly world, the P/E ratio for a given stock would be in line with that of other companies in the same industry. This logic holds that if the P/E is too high, then the stock is overpriced. If it's too low, the stock is underpriced and a buying opportunity.

As of March 17, 2017, the P/E of Facebook (FB) is 40; Amazon (AMZN) is 173; Netflix is 336; Google (GOOGL) is 29. Analysts like to call these four companies the “FANG stocks,” from the first letter of each stock. Of course the four are completely different businesses, all competing with each other to some extent.

What explains such a crazy range of P/E? In other words, how can Amazon be worth 173 years of its own profit when Google is worth only 29 years of its profit? For that matter, why would anyone even pay a price of 29 years’ worth of profit for any share of stock, let alone 336 years’ worth?

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But the analysts are wrong

The answer is that P/E ratios do not determine stock price but are simply an outcome of factors that drive the share price and the simplistic comparison of that price to earnings.

And what if a company has no earnings — or is even losing money and thus the “E” is a negative number? That may be a temporary situation in a single fiscal quarter, or it may be a multi-year issue. That's often the case for biopharmaceutical companies that might report financial losses for five to 10 years before having a product that generates revenue and profit.

The real answer is “supply and demand.” If there are more buyers than sellers, the price of the asset is bid up, and if there are more sellers than buyers, the price drops. But what determines whether someone decides at that moment to buy or sell?

There is an underlying notion that buyers and sellers are rational, analytical, and methodical. They are not. It also assumes that all investors have the same underlying theory of what determines the value of a stock. They do not.

As I discussed in my article “How to Turn Bad News into Great Profits With Value Investing,” a single media headline or blog post can cause a sudden change in a stock’s price. Did everyone have time to do a rigorous revised financial analysis based on that headline or blog post and run that against their investment thesis? Of course not.

Reported earnings are a choice

Before you put too much weight on the P/E ratio, be aware that the reported earnings of a company are primarily a choice, not a fact. A company can choose to report higher or lower earnings for a given fiscal quarter, or for years at a time, based on hundreds of decisions about how to use the accounting rules to achieve that outcome.

That hardly seems fair, but it’s the reality of accounting. It explains why most U.S. companies also report “non-GAAP” earnings (i.e., a calculation of profit that does not follow the rules of GAAP, the generally accepted accounting principles).

You also may hear reference to “free cash flow” — Amazon emphasizes that financial metric — and there is no official definition of how to calculate that.

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We are the “price takers”

So what determines a share price? Don’t tell anyone this, but it’s a pyramid scheme — I will buy a stock only if I think someone is later going to buy it from me at a higher price, and he or she will buy it from me only if they believe the same. This works great if you have an investment horizon of 20 or 30 years.

This logic doesn’t address the fact that a majority of the daily trading volume on U.S. stock exchanges is high-frequency trading — the buying and selling of shares of stock with the buy and sell of those trades occurring within one second or less of each other. This undermines the supply/demand theory.

Investors like you and me are “price takers,” as the economists would say. What we should do is read the various opinions about a stock’s price and then interpret those. We can’t assume that Google is underpriced at a P/E of 29 or that Netflix is overpriced at a P/E of 336. Though both might be true.

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About the Author

Fred Whittlesey

Fred Whittlesey

Freelance Contributor

Fred Whittlesey is a freelance contributor for Moneywise.

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