Price-earnings ratio has flaws

Donald Saltz

November 15, 1991|By Donald Saltz

The price-earnings ratio is one of the most simple, yet most valuable, tools available to the stock market investor. It compares earnings per share to the selling price and is a genuine guide to the fairness of that price. However, the P-E ratio can also be very misleading.

The stock market trades on expectations. This is why the market has been strong during our current recession, with a lot of analysts believing the recession will soon end and corporate earnings will benefit a great deal from the recovery.

On the other hand, the P-E ratio is telling us what has happened. It compares past earnings to the current share price. This is a decent indicator for many companies whose profits are consistent, but for firms that have come on hard times or have rebounded into prosperous times, the P-E, instead of being helpful, deceives the investor.

Take a look at British Steel which nearly had a major local presence after having negotiated to invest in Bethlehem Steel, an arrangement that, apparently, has been called off. Last Monday, British Steel reported a more than 90 percent downturn in profits, with company comment that probably business will continue soft.

British Steel's share price fell that day from 20 3/8 to 16 3/8 , a four-point loss. Yet the price-earnings ratio alongside the stock price was only four, which is especially attractive as was the stated yield of 12.2 percent. The new, lower earnings had not yet been incorporated into published statistical data. Any investor studying the available statistics was getting a mixture of data from the present and from the past, which was entirely misleading.

The very low P-E and high yield for British Steel raises a red flag to the knowledgeable investor who will likely realize that there have been recent changes. However, this would not be so evident for a company whose P-E was not very low.

Take for example, Gaithersburg-based Penril DataComm Networks, until last year known as the Penril Corp. The shares are traded on the American Stock Exchange. In 1985, Penril's earnings hit the skids and they got much worse in succeeding years as a result of over-expansion.

In its last year of good earnings before the losses arrived, Penril sold between a range of 10 1/4 and 14 5/8 , with its double-digit P-E considered normal. The share price ranged from about 7 to 14 the following year, with the P-E staying abnormally high because past earnings were propping it up.

However, Penril began concentrating on its data communications businesses and the company did a sharp, favorable turnaround. The company went from a $2.51-a-share deficit in 1987 to earnings of 26 cents a share in '88, and 61 cents in '89, all of these adjusted for a share distribution. As the P-E had been artificially low during the tougher times because of the inclusion of prior profits, the stale earnings that were later included kept the ratio artificially high as actual profits were rebounding. The ratios were misleading.

As earnings deteriorated in the late 1980s for MNC Financial and the USF&G Corp., both of Baltimore, the P-Es were misleading because they were reflecting past earnings. This is why it's very important for investors to keep abreast of the latest quarterly results for most companies in which they're interested. Special factors can affect earnings and make the P-E virtually meaningless.

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