How to Use the P/E Ratio and Other Tools When the Market Is Overvalued

In the current market environment, it almost seems as if value investing is dead. It’s been this way for at least the past few months. This means value investors have been struggling in many cases and at least one hedge fund manager is discussing his concerns with investors.

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  • In October of last year, David Einhorn of Greenlight Capital described the problem in his quarterly letter to investors:

    “Given the performance of certain stocks, we wonder if the market has adopted an alternative paradigm for calculating equity value. What if equity value has nothing to do with current or future profits and instead is derived from a company’s ability to be disruptive, to provide social change, or to advance new beneficial technologies, even when doing so results in current and future economic loss?”

    In other words, Einhorn asked what if value is dead? Einhorn started his hedge fund in 1996 and delivered an average annual return of 16.5% in the first twenty years although he has struggled lately. He manages about $9 billion now.

    He clarified his thinking in his most recent letter:

    “We have a value orientation and we take comfort from the margin of safety afforded by the low valuations of our long investments. Though most people understood our last quarterly letter as tongue-in-cheek and while we certainly don’t believe value investing is dead, it is clearly out of favor at the moment.”

    But, he is not changing course. “While it feels like we have been running face first to the wind, we don’t intend to capitulate and are sticking to our strategy of being long misunderstood and shorting ‘not value,’” Einhorn wrote.

    Applying Value At Difficult Times

    Einhorn’s struggle and concerns are doubtlessly shared by many individual investors. Value doesn’t seem to work in some markets. The chart below shows that even the world’s greatest value investor struggles through this problem at times.

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    Berkshire Hathaway lost almost half of its value during the Internet bubble. At the time, analysts question whether or not Buffett was capable of delivering returns in the new era that the Internet ushered in.

    In the long run, Buffett, and value prevailed. But, it can be difficult for those of us who aren’t Warren Buffett to be out of synch with the market. That means we need to consider how to adapt value to the market we have rather than insist on applying rules we would like the market to follow.

    Relative Valuation Beats Absolute Rules

    Valuation ratios adapt to the market. For example, because stocks and bonds are alternative investments, we expect P/E ratios to rise as interest rates fall.

    This is because bonds are less attractive as interest rates fall and we expect more money to flow into stocks than bonds at times like that. The increased demand raises their valuation levels. Likewise, rising interest rates makes bonds less attractive than stocks and higher rates dampen valuation levels.

    In addition to external factors like interest rates, internal factors like growth rates also affect valuation levels. The next chart shows the price of Netflix (Nasdaq: NFLX) and its price to sales (P/S) ratio.

    NFLX

    Source: Standard & Poor’s

    First, the P/S ratio is used in this chart because it is among the most broadly applicable fundamental metrics. Many companies will report large changes in earnings due to various accounting charges. Sales tend to change with less variability and that prevents wide swings in valuation metrics.

    Over the past five years, the average P/S ratio for NFLX has been 6.1. This is considered high by many analysts on an absolute basis. But, the company has reported sales growth averaging 22.5% over that time and the stock price has increased by almost 2,000%.

    Applying static valuation rules, such as not buying stocks with a P/S ratio above 2, would miss many of the biggest winners.

    All valuation ratios should be considered from a relative perspective. Stocks with above average growth deserve above average valuations.

    Adapting Measures for Growth

    Perhaps the simplest adaptive fundamental metric is the PEG ratio. This metric compares the stock’s P/E ratio to the company’s reported earnings per share (EPS) growth rate.

    The PEG ratio recognizes that investors are willing to pay a premium for growth. In fact, companies growing earnings at 30% a year, for example, should have a higher P/E ratio than a company that is growing earnings at 3% a year.

    The PEG ratio recognizes this fact. The ratio is found by dividing the P/E ratio by the EPS growth rate. A ratio of 1.0 indicates a stock is fairly valued. PEG ratios less than 1 highlight stocks that are undervalued no matter what their P/E ratio is. PEG ratios greater than 1 show a stock is potentially overvalued.

    Another technique investors can apply is to apply the current ratios to the industry average ratios. Companies growing faster than the industry average deserve higher than average valuations.

    Long term average ratios for industries can be difficult to find but they are available at the web site of a New York University business professor.

    In addition to that technique, a company’s valuation can also be compared to its own long term averages. A below average ratio could indicate either slowing of the company’s growth prospects or a bargain. Just a little research should help an investor decide.

    The small amount of research needed to avoid buying overvalued stocks will be worth it as risk increases. The fact that value is underperforming indicates we are most likely in the late stages of the current bull market. It is the kind of market where a Buffett or an Einhorn underperform.

    Avoiding the risks associated with the next bear will require further research. If you are uncomfortable doing your own research, there is a TradingTips.com trading service, Triple-Digit Returnswhich uses a very specific system for choosing the right stocks to trade.

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