Never Enough Lessons on Forward PE

Never enough lessons on forward PE, especially for cyclicals. Today dry bulk shipper Dryships hit an all-time low of US$21.8, down from a peak of US$120, and down from the US$64 back when Barron's called the Buy on the stock. Everyone is wrong at times, and being wrong for decent reasons is fine. But in a previous post in April, we outlined that we mostly took issue with Barron's completely missing some of the most important issues with dry bulk commodities transportation stocks such as DRYS and worst of all arguing for the stock given a very low forward PE, which was completely ridiculous given that the bulk shipping industry is prone to earnings swings of +/-80% within short, unforeseeable periods of time. The below was our previous excerpt from Barron's:

Global trade might slow this year, but it will come back eventually, and DryShips' profits -- and shares -- should move up over the long term, even if 2008 growth turns out to be lower than Wall Street expects. At its recent quote of 64, DryShips stock was trading at a price/earnings ratio of 3.5 times consensus analyst earnings estimates of $18.18 a share this year and about 5 times the $12.22 forecast for 2009. DryShips also trades at a more than 50% discount to its peers, although rivals generally seek long-term contracts, which are less volatile.

And then our following criticism.

This article fails to mention that dry bulk spot rates are extremely volatile and forecasting where they will go is subject to massive room for estimation error, even for industry veterans. Thus forward PE can be very deceptive and is a silly way to look at the companies. Last year Clarksons research surveyed a large collection of readers to forecast where rates would go in 2007 and EVERYONE was wrong by a large margin. (they spiked massively) They can also spike massively downward in the same fashion... If forward earnings ends up being 80% lower, which historically isn't a crazy notion at all if you look at a rate chart, your PE will be 5x what you thought it was. Thus using forward PE is pretty silly given its forecast error range is so wide as to be near meaningless.

Well this post came under some fire from commenters on Seeking Alpha for either a) being written by an author looking to push the stock down (we wish we had that level of influence on The Stalwart) or b) not understanding that without earnings forecasts and resulting forward PE's, then there wasn't a way to make an investment case:

If you think "... using forward PE is pretty silly given its forecast error range is so wide as to be near meaningless" then you must think there is no meaningful way for an analyst that follows DRYS to do his job (to forecast earnings). THAT'S silly.

There are many tools for analyzing a company beyond just forecasting its next year's income. And for highly cyclical ones with little visibility forward earnings barely deserves to ever a tool, and is usually much more dangerous than useful.

DRYS is now at US$24, down massively due to, well, the fact that the Baltic Dry Index, which is an index for bulk shipping rates, has fallen from a peak of 11,500 just earlier this year to below 3,000 currently, for a 74% decline in just a few months. The rates for DRYS bulk ships have fallen in a roughly similar fashion. This dramatically changes the earnings forecasts of analysts across the board for 2009 and onward, though even these new earnings forecasts remain rubbish given the fact that rates are so volatile and for the most part"unforecastable" for dry bulk shipping. They could cut their earnings drastically, only to see a surprise rate rally in 2H09. Dryships 2009 earnings forecasts have dropped 25% already, though this to me looks timid given the drop in rates seen. DRYS is now at a 2009 PE of 2x, but again, if the current rate situation were fully reflected in analyst numbers would have to come down substantially further, as much as to say make the PE 15x or worse.

Now maybe DRYS is decent here, I haven't done a full analysis of the company's assets (at US$24 maybe the scrap value of its fleet could be enough to argue for value, potentially), nor intend to in this space. But the point is more about using forward earnings as a justification rather than whether buying DRYS at $64 was correct or not. At the very least, the Dryships debacle is another great example of forward PE's being undependable for this industry and many cycical industries. What's even more shocking is that some top-tier transport analysts use forward PE's when arguing for these types of stocks and some fund managers don't bat an eyelid upon hearing such justifications. Highly cyclical companies with low earnings visibility = companies where forward (forecast) PE is essentially meaningless.

Comments

[dunnage]

Take the S&P stocks today. Trailing earning I can work with, but would anyone accept 2009 earning projections from even an analyst you may trust? Nobody has been predictive of a damn thing lately.

I have noticed that forward earnings are often used these days, people don't want to know that a PE of 10 or less reached before the bottom of a Secular Bear. Go to the S&P site and check "their" PE -- scary at today's market level. So you have all types giving PEs based on forward projections -- peaches and lemons. And everybody, and I mean everybody knows that current numbers are too high and that's all anybody knows.

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