The PE Ratio 

The PE ratio can often behave differently for cyclical companies.   Generally speaking, conservative investors often shy away from a high PE ratio and consider buying a company when the PE is depressed.  Cyclical companies have sales and earnings that tend to undulate over time: they follow the business cycle, moving up and down in synch.  The PE ratio, the price of the stock divided by its earnings per share, changes over time too.  Let’s consider two extremes: at the onset of a recovery and when the economy starts to slide into recession.

Recovery

Sales and earnings are depressed, but factory orders look good.  All signs are that sales and earnings should recover in the next few quarters.  The market often responds by bidding up the stock price.  With current earnings depressed—and the stock price elevated—the result is a high PE ratio.  It’s often useful to look at published PE ratios based on projected earnings.  A discrepancy between trailing and projected PE ratios indicate that the market thinks a recovery is imminent.

Downturn

Flip the discussion for a recovery around and you see that the PE ratio during a downturn should be low!  Earnings are still robust, but factory orders are slowing down.  The price of the company is bid lower, pushing the PE ratio down.  Once again, comparing PE ratios based on published trailing and projected earnings can give one some insight into what’s happening.

Is it any wonder that we stick to growth companies: companies whose sales are impervious to the business cycle?  It certainly gets rid of the complications discussed above!