Don’t Let a Low P/E Fool You

Toll Brothers (TOL) is set to report earnings tomorrow, and I’m afraid to watch. Don’t get me wrong. Toll is a terrific company. I wish I had bought its shares years ago. Heck, even two years ago. But I’m pretty nervous about the outlook for housing stocks.
I’ve been looking at several housing stocks, and I have to say that I don’t see any good bargains. One of the problems of analyzing housing stocks is that their price/earnings ratios can be very misleading. Let Professor Eddy explain.
While the price/earnings ratio can be a very valuable tool, sometimes it doesn’t tell us the right information. The reason is that the P/E ratio is actually a weird hybrid number. It compares a fixed-point number (the price) to a rate (earnings). Even many experienced investors don’t realize this.
With a fixed-point number, we always know exactly what it is at a given time. That’s not so with a rate. For the earnings number, we’re really asking how much did a company make between two points. Since there’s a lag time, these points are usually somewhat dated. For Toll Brothers, it earned about $4.05 a share between July 31, 2004 and July 31, 2005. That’s a period of 16 months ago to four months ago.
With Toll trading around $34 a share, it appears to be a bargain at 8.5 times earnings. Using a hybrid number like P/E ratio is kosher, but we have to recognize when it can trick us. It’s almost like trying to weigh something with a ruler.
Generally, I think it’s better to look at the forward price/earnings ratio. That compares next year’s earnings with today’s price. That’s better, but still we have to rely on analysts’ estimates. That can be a dangerous game, and with my favorite stocks, I prefer to set my own estimates. If you’ve been reading me for awhile, you’ll remember that Frontier Airlines (FRNT) earned 16 cents a share, far above the two cents Wall Street was expecting. Right now, Wall Street expects Toll to make $5.25 a share next year. That seems too high to me.
Even using a forward price/earnings ratio has its downsides. It particularly screws up the readings of cyclical stocks. These are companies whose fortunes are heavily tied to the economy, like oil stocks or homebuilders. ExxonMobil (XOM) is a very good company, but its earnings-per-share declined four times in five years between 1998 and 2002.
No matter how good you are, it’s hard to make a profit when all the arrows are negative in your industry. In 2002, I don’t remember Congressional hearings about the poor fate of the oil companies, but ExxonMobil was able to get by. Today, of couse, it has huge earnings and a lot of complaints.
For a cyclical company, the trick is really managing your way between the good times. This is why economists pay such close to attention to things like new home sales or orders for durable goods. The cyclical stocks give us a good idea of how strong the economy is.
Generally, I usually don’t favor a lot of cyclical stocks. There are some on the Buy List like Donaldson (DCI) and Danaher (DHR), but I prefer stocks that do well no matter how well the economy does. Like a lot of things, I’m not smart enough to predict the movements of a $12 trillion economy.
With homebuilders, there’s always a reckoning. Toll Brothers dropped over 80% from 1987 to 1990. In 1994, it fell 50%. From 1998 to 2000, it fell 50% again. And it nearly did it again from 2002-2003. So far, the stock is only 42% off its high since the summer. I get the feeling that Toll’s earnings aren’t going to come in at the level Wall Street wants. We’ll know more tomorrow. Until the dust clears, I’m staying away from the housing sector.

Posted by on December 7th, 2005 at 3:25 pm


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