When the financial media touts a stock based on the P/E ratio, be aware of its drawbacks.
Popular advice is to buy when the P/E ratio is low and sell when the P/E ratio is high. That does not always work. Sometimes it works backwards. Displayed below is a chart of Apple's P/E ratio starting when the P/E ratio was 116. Hear a number that high and most investors dismiss the opportunity. Watch the financial media dismiss the stock because its high P/E ratio and you would be certain to pass the opportunity.
To understand this dilemma, we must understand the dynamics of the P/E ratio.
If one does not price in an industry downturn, then the Price to Earnings ratio may look deceivingly attractive. Take for example from 2005 to 2007 when the housing, banking, and auto sector's earnings were through the roof. Sales of houses and autos were high based on cheap credit and banks earnings were high due to allowing for unusually low loan losses.
This creates a temporarily high "E" and depresses the P/E ratio which tricks many investors into buying. In 2009 when earnings came to a screeching halt the "E" was abnormally low, the exact opposite occurs, and investors are afraid to buy because the "high" P/E ratio.
This is exemplified in Wells Fargo's P/E ratio in 2009. During the financial crisis, when earnings were temporarily depressed, most P/E calculations ceased to make sense. The intelligent investor must recognize this and realize it could be an opportunity.
During the times of irregular earnings, the intelligent investor should consider the price to sales ratio. Take a look at the difference between the two in the chart below. When the high P/E of 2009 indicated caution, the Price to Sales indicated opportunity.
Anyone investing in WFC knows which ratio proved to be a better indicator. Warren Buffett (Trades, Portfolio) is one. Below is Warren's WFC holding record since 2009.
Could a Price to Sales ratio approaching the levels not seen since 2007 be the reason for Warren slowing his pace of buying WFC stock?
Investors considering purchasing Apple today must consider the drawback of the P/E ratio. Waiting until the P/E ratio was near "normal" levels would have kept us out of the stock during one of the most profitable periods ever. If you expect Apple to continue the tremendous rate of earnings growth, perhaps the P/E ratio may work. If you expect an industry correction and believe earnings are at a peak, take caution.
