Valuations and Volatility: The Highs and Lows

When building a portfolio, investors will often look at a stock’s valuation to determine whether or not it is a good investment.

The most common valuation measure – price-to-earnings ratio (P/E) – takes a stock’s market value and divides that number by the stock’s earnings per share from the previous four quarters. Often used as a tool to determine the value of an investment, the measure of a P/E ratio can suggest the future performance of a stock. This ratio can also help determine a stock’s value by providing a mathematical reference as to how much investors are willing to pay per dollar of earnings. For example, a stock with a P/E ratio of 15 indicates that investors are willing to pay $15 for $1 of earnings.

Typically, an investor will see a high P/E ratio and gather that the stock is expected to see higher earnings. The flipside is that it also may indicate the earnings are not keeping pass with the price and thus the stock is expensive and not be a good investment. Alternatively, when facing an investment with a low P/E ratio, an investor will assume the stock is undervalued and possibly a strategic buy.

While taking a stock’s P/E ratio into consideration can be useful when constructing a portfolio, by no means is it the ultimate indicator of market success. In fact, this measure can be a misrepresentation of value.

In determining P/E ratios, the odds of a miscalculation or misinterpretation are relatively high because the earnings figure that is used is reported directly from the organization itself. As such, the number can be manipulated and misreported, resulting in an inaccurate ratio.

Furthermore, even with a sufficient valuation, the measure is easily misinterpreted due to imbalanced comparisons when looking at other investments. Investors often evaluate a stock’s P/E ratio based on figures reported by other stocks across the entirety of the market. This hinders an investor’s judgment severely – growth and earnings vary drastically between sectors. By only looking at this single factor, investors wrongly evaluate a stock’s valuation by comparing the investment to stocks in unrelated industries. Investors essentially end up trying to compare apples to oranges.

Valuations – Factual or False?

Based off of valuation measures alone, market pundits have recently spoken out against certain investments with high P/E ratios, criticizing that these stocks are set to lose value. Particularly concerned with low volatility investments, skeptics note that these high valuations are likely to lead to an expensive low volatility space, hurting the sustainability of the investments.

Looking at a single, isolated factor – an investment’s P/E ratio – it could be interpreted that low volatility stocks are expensive and that the strategy will ultimately see lower returns.

However, a single factor does not dictate an investment’s future performance or value.

There are dozens of factors that can be taken into consideration when evaluating a stock. Unfortunately, though, these various elements are not given equal attention. Quantitative measures are often given priority over qualitative characteristics, leaving many relied-upon valuations inefficient in practice. This oversight in valuations presents a critical limitation when assessing an investment.