Being a company with only a 2-Star Business Predictability rank, such as Illinois Tool Works Inc. (ITW, Financial), might make a valuation method based on earnings difficult. Due to accounting allowances or "one time" charges, this manufacturer of industrial products and equipment might be difficult to value using the P/E ratio.
Therefore, we should identify another method that verifies if the earnings based method is a good candidate. A financial data point that is similar to earnings, but less prone to accounting manipulation, is revenue. Take a look at the chart of revenue per share and earnings per share.
If you notice EPS not in sync with revenue, as seen in 2002 and 2009, it may make using theP/E ratio as a valuation tool somewhat risky. If earnings are temporarily very low because of a one-time charge or accounting rule, as often occurs during a financial crisis, the P/E ratio will be high. If temporary, a high P/E ratio may mislead investors into believing the stock is expensive. In the case of ITW, the P/S ratio and P/E ratio are quite similar. This means the P/E has historically been a fair tool to value ITW.
In past times of tight-money supply, in the case of bank stocks, there were large "one-time" charges and countless other accounting allowances. Witnessed in the chart of Wells Fargo below, the P/E ratio was an extremely risky valuation tool. A 30 P/E ratio would have scared many out of Wells Fargo (WFC, Financial) in 1999, only to see a 100% increase in price over the next few years. The 13 P/E ratio would have attracted "value" investors in 2007, only to see a 50% price drop shortly after.
It is important to understand the pros and cons of each valuation method. Understand when the P/E ratio is useful and when it may not work. Study the other methods including price to inventory, price to property plant & equipment. Get creative and make your own unique method.
Each and every company is different. Sometimes it takes multiple methods to identify a margin of safety. Does price to COGS, or price to SGA work? Study the methods of the investment greats like Seth Klarman and David Tepper. Understand what made James Barrow's ITW investment so profitable.
Play with the interactive charts and enjoy the investing process.
Thank you to GuruFocus.com for providing the interactive charts.