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Price-earnings ratios are some way investors determine whether equity prices are mean, costly, or fairly valued. But are they the best way to gauge stocks?

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by Ben Steverman

The price-earnings fixed relation is a accredited tool for investors. But these days, in the identical proportion that the couple prices and earnings fluctuate rapidly, the p-e tool is getting extra watchfulness because it tries to answer a key theme of inquiry: With the broad Standard & Poor’s 500-stock index down almost 20% from its October pinnacle, are stocks cheap plenty to make them a great bargain for long-term investors?

Fueling the altercation over p-e’s, the same family can look of little value or dear, depending on how the p-e ratio is determined. The p-e ratio is calculated by means of dividing a stock’s price (or the value of any index) by its annual earnings. A high p-e can be a presage that a stock is any one overvalued or poised for stellar shooting. A low p-e can be a sign of a post that is a good long-term value—or a sign of a company in trouble.

While a stock’s excellence is easy to determine, earnings are harder to measure. Some investors prefer forward earnings, often determined by analyst estimates for earnings of the next 12 months. The problem is that analysts are often wrong, as they require been about financial stocks over the spent year. "No one has a full crystal ball," says Brian Reynolds, chief market strategist at WJB Capital Group.

For investors looking for more assurance, trailing earnings are preferred. This measure of earnings, often based on the past 12 months, has the disadvantage of looking wavering while the stock market is often looking prompt, trying to predict future trends. Trailing p-e’s "won’t tell you much about turning points," Reynolds says.

In either declension-form, investors stand in want of to determine how abundant they reliance the "e" in the p-e ratios.

Until a year ago, the emporium had learned to expect large earnings from financial stocks. Little did investors know how fragile those proceeds were. With firms relying so much on subprime loans and other questionable misdoing, "those proceeds have existence obliged gone at a distance forever," says John Merrill, chief investment officer at Tanglewood Capital Management in Houston. "You want to use [p-e ratios] as a starting station, but you want to application a little common sense on how sustainable those earnings are," he says.

The trailing p-e ratio for the S&P 500, which includes the first of the second-quarter earnings reports, is 16.4, according to Thomson Reuters (TRI). The fore p-e is 12.2. The average p-e since 1935 is 15.8, but stock valuations possess been much higher in recent decades, with the average p-e atop of 20 in the past 25 years. That puts trailing p-e’s in a gray area, not obviously of little value nor expensive. The forward p-e of 12.2, however, is cheap by most historical comparisons.

But that forward p-e includes some ambitious assumptions about where earnings are headed in the next year. After an expected 17.1% fall because income in the second quarter, Thomson Reuters says, analysts are predicting an earnings rebound of 12.7% in the third part quarter, followed by a 61.5% jump in the fourth quarter, and increases in the heavenly heights 30% in the foremost half of 2009.

Ashwani Kaul, director of research at Thomson Reuters, points out that these estimates assume a big rebound for financial earnings. "Maybe the banks have turned the corner," he says. Hopes were raised by better-than-expected second-quarter earnings from Citigroup (C), Wells Fargo (WFC), and JPMorgan Chase (JPM). However, "we’re not as confident in the ‘e’ as we were just a year agone, because the analysts take been so maltreat in succession their projections," Kaul says. That makes the stock market jittery despite the low forward p-e ratio.

With so many questions about the reliability of p-e ratios, in that place is naturally a lot of contest about for what reason useful p-e’s are to investors in picking shares.

"I’ve never found p-e ratios to be a particularly good screen for me," says John Wilson, principal person technical strategist at Morgan Keegan. After all, the stocks that do the best in the stock market are those that beat their earnings estimates, he says. Some of the best-performing stocks can have higher p-e ratios, reflecting their more valuable growth prospects.

Brian Gendreau, investment adroit tactician at ING Investment Management, says p-e ratios are "a very strong and powerful indicator." He adds, though, that p-e’s are not a good way of predicting the near time to come. "Sometimes, the place of traffic is common because advancement prospects are not very good," Gendreau says. "If valuations are inexpensive, they can stay that way for quite a while."

For example, energy public funds tend to have low p-e’s—with the average under 10—because, defiance rapid growth from this sector, most investors assume huge profits won’t be sustainable when mechanical value prices cool off.

"Just because something is cheap doesn’t mean it’s a bargain," Reynolds says.

Still, p-e’s can be a good guide for investors with a long space of time horizon. In the past, periods at what place shares have with little elevation p-e’s have been great times to invest, as long as you’re not eager for quick returns.

While valuations are cheap, the broader stock market’s recent momentum is "dreadful," Gendreau says. But, he says, p-e’s demonstrate that stocks should eventually restore—perhaps in a year to 18 months.

"If you’ve got a two- or three-year time horizon, this is more of the first grade time to buy," Merrill says.

The concern of many on Wall Street is what happens to prices, earnings, and p-e’s over the nearest year. More financial troubles and an economic slowdown could prove that today’s p-e ratios are conformable or even overly optimistic. But for the sake of individual investors with the stomachs to treat of a wild ride, p-e’s say this might be a good time to buy.