For many investors, a low Price/Earnings (P/E) ratio is a sign of value. But don’t you bet on it – at least, not yet. According to Michael T. Darda, chief economist for MKM Partners LLC, analysts have overestimated earnings by an average of 30% to 35% in the last three recessions. For millions of investors who use low P/E ratios as a litmus test for selecting their investments, that’s going to be a rather unpleasant shock.

If Darda is right, and our research seems to suggest he is, so-called “cheap stocks” may not be all that cheap. For proof, we can turn to some plain-old high school math. P/E ratios are calculated by taking the price of a stock (the numerator, or the “P”) and dividing it by earnings per share (the denominator, or the “E”). The higher the denominator, the lower the P/E ratio and, by implication, the cheaper a stock appears.

However, if higher denominators can make stocks appear “cheap,” then the opposite is true, too, and that suggests that stock prices may have a lot farther to fall – despite the fact that they’ve already tumbled 40% or more.

Just how much farther is anybody’s guess, but the outlook is not good.

For instance, according to Forbes writer James Clash, “more than a year into the market downturn that threatened Morgan Stanley’s (MS) survival, the 17 analysts covering the company cut their 2009 mean earnings estimates by 36% to $3.63 per share.” Given Darda’s observations, there may be another 35% to go, which would put total expected earnings cuts at 71%.

That sounds harsh, but it may not be out of line. Thompson IBES reports that the analyst community as a whole has cut 2009 earnings expectations by only 7.5% for the Standard & Poor’s 500 Index. If they are to be believed, that means that the analyst community expects the average S&P 500 company will have to grow earnings by 15% next year to $91, according to Clash.

We don’t know about you, but a time when recessionary flags are flying, we have a hard time buying that (pun absolutely intended).

That’s why – at the risk of igniting an e-mail firestorm – we point out that analysts are paid to have opinions and a huge body of evidence suggests that they’re strongly encouraged to make them bullish. Not only is this a cozy relationship for investment bankers in general, but it has historically helped Wall Street generate huge commissions from an anxious retail investing public that is desperately seeking good news. This bullish predisposition may be especially true at a time when investors are not inclined to buy – and with good reason.

Compounding the problem is the fact that many analysts focused on specific industries or companies tend to become quite myopic. Far too many don’t think outside the box and, as a result, are all too frequently surprised when macro-level events come crashing in on their little world and down on the companies they follow.

Investors who rely heavily on Wall Street analyst estimates are, in effect, driving down the highway using only their rearview mirror. The results are all too predictable.

Among the more infamous examples of these errant estimates was the group of analysts who, back in 2001, continued to recommend Enron Corp. stock all the way into bankruptcy and congressional hearings, based solely on their own “optimism.” Only when Enron shares were trading at less than $1 did the majority of analysts change their recommendations to a “hold.”

When it comes to Wall Street, the fox clearly does guard the financial hen house, so to speak.

In the interest of fairness, we should mention that there were “accounting irregularities” in the Enron case. But that really shouldn’t let anybody off the hook.

What’s happening now – and why we’re leery that things may not be as they seem – is that overall business and economic conditions are deteriorating faster than management is willing to publicly acknowledge (although we’re now watching these same management teams slash work forces and shutter plants at a rate we haven’t seen in years). And since management “guidance” (the sarcasm you detect is intended) is what drives and shapes Wall Street earnings estimates, this is why things are probably going to get worse before they get better. The earnings figures used in most P/E calculations haven’t yet been reduced.

As for the ratings agencies such as Standard & Poor’s, Moody’s Investors Corp. (MCO) and A.M. Best Co., these, too, are problematic when it comes to the earnings and the ratings that help drive them. Supposedly independent, it’s been common knowledge for years on Wall Street that firms wanting higher ratings need only coddle the agencies using a combination of fees and information. Of course the agencies will deny this but history suggests that’s like the pot calling the kettle black.  Historically, for example, Moody’s, S&P and Fitch Ratings Inc., have each earned huge amounts of income from fees being paid by the issuers whose credit they’re supposedly rating. That’s changing, of course, but as the credit crisis has highlighted so aptly, probably not fast enough.

So what does work?

P/E ratios are a start. But that longstanding indicator should be regarded as a relative measure of potential price and performance rather than the do-all stock-screen selector so many investors utilize them as.

When we analyze a company, we prefer to see expanding sales, advancing earnings and plenty of cold hard free cash flow. There’s an old saying on Wall Street that “nobody ever went broke on accrual accounting,” but clearly plenty of companies have figured out lately that they can go broke without cash. The best example may well be Detroit’s Big Three, which are grappling with this seemingly new reality even though we, as individuals, deal with it every day. As my six-year old son recently stated: “No cash … no dinner.”

One other excellent indicator is a so-called “PEG” ratio (the P/E divided by the growth rate) of less than 1.0. While it’s more commonly viewed using 12 month trailing earnings, we find it much more stable when viewed against a historical stream of data that’s a decade or more in length. Not only does this help screen out the volatility associated with much shorter time periods, but we find that companies with low PEG ratios calculated in this manner seem represent good value over the longer term.

Especially when compared to a deflated “E” – earnings.

Source: Stocks May Not be Cheap Enough, Yet – And Here’s Why