We don’t talk that much about earnings on this site. We prefer to focus more on the numerator of the P/E ratio and analyze the price of a security rather than the earnings (or sometimes lack thereof). One of my pet peeves with P/E ratios is the common misconception that a low Price to Earnings multiple is a sign of an undervalued company. The problem with this myth is that a P/E ratio could be low for a perfectly good reason. If the price of a stock gets crushed, the ratio is going to decline well before those earnings numbers are ever released. In this case, the market begins to price in the bad numbers, and a shrinking multiple is well-deserved and doesn’t indicate that the “stock is cheap”.
But today we’re going to look at the opposite sort of action: when a stock consistently peaks at about the same price, but the earnings per share continue to increase. In other words, it’s the E-growth in this ratio that is shrinking the multiple, not a lower P, as mentioned in the problem-example above. This is what’s called P/E Compression. And as we always do as technicians, we are studying the behavior of the P (price) here, but in this case relative to the positive changes in E (earnings).
Carter Worth, Chief Market Technician at Oppenheimer, is an Allstarcharts favorite – and has been for a long time. This Friday he did a terrific job of explaining the P/E compression that has been developing in shares of Google ($GOOG) over the last 4 years. His detailed explanation comes within the first 2 minutes of this video from CNBC:
Great stuff Mr. Worth