The price-earnings (P/E) ratio is the most widely used ratio in investing. Searching the term ‘P/E ratio’ on Google will return 2.3 million results. Simply put, the P/E ratio is the ratio of the stock price divided by its earnings per share (EPS). If company A is trading at $10 per share and earning $2.00 per share, then A has a P/E ratio of 5. This means that it takes 5 years for the company’s earnings to pay off its initial investment. If you invert the P/E ratio, we get the E/P ratio, which is the return on our investment. In this case, a P/E of 5 equals a 20% return.
The P/E ratio is convenient and very easy to use. But that’s why so many investors misuse it. Here are some common misuses of the P/E ratio:
Using the final P/E. Final P/E is a company’s price-earnings ratio over the past 12 months. For cyclical companies coming off an earnings peak, the P/E ratio is misleading. Your trailing P/E may seem low, but your front P/E may not be. Forward P/E is calculated using a company’s expected earnings per share. The forward P/E is more important than the final P/E. After all, it is the future that counts.
Neglecting earnings growth. A low P/E ratio does not necessarily mean that the stock is undervalued. Investors should take into account the growth rate of a company. Company A with a P/E of 15 and 0% earnings growth may not look as attractive as Company B with a P/E of 20 and 25% earnings growth. The reason is that if both stock prices remain the same, after 3 years, company B’s P/E will decrease to 10.3 while A will still have a P/E of 15. The moral of the story here is not to use the P/E ratio alone to judge the value of an asset.
Ignoring the one-time event. The P/E ratio always includes a one-time event, such as the cost of restructuring or downward adjustments to goodwill. When that happens, the ‘E’ in the P/E ratio will appear low. As a result, this event inflates the P/E ratio. Investors will do well to ignore this one-time event and look beyond the high P/E ratio.
Ignoring the Balance Sheet. That’s right. Investors often neglect cash and long-term debt built into the balance sheet when calculating the P/E ratio. The truth is, companies with more net cash on their balance sheets typically get a higher P/E valuation.
Ignoring the interest rate. Using only the P/E ratio for our investment decision will produce disastrous results. As explained above, when we invert the P/E ratio, we get the E/P ratio. The E/P ratio is essentially the return on our investment. A stock with a P/E of 10 is yielding 10%. Stocks with a P/E of 20 yield 5%, and so on. If the interest rate goes up to 6%, then stocks trading at a P/E of 20 will be overvalued, all else being equal.
As with other financial ratios, the P/E ratio cannot be used solely to value a company. The interest rate fluctuates, earnings per share goes up and down, as does the stock price. All of this must be taken into account when choosing your potential investment.