Common Misuse of P/E Ratio
Price Earning (P/E) Ratio is the most widely used ratio in investing.
Searching the term ‘P/E ratio’ into Google will yield 2.3 million results.
Quite simply, P/E ratio is the ratio of Stock price divided by its Earning per Share (EPS).
If a company A is trading at $ 10 per share and it earns $ 2.00 per share, then A has P/E ratio of 5.
This means that it takes 5 years for the company’s earnings to pay up for your initial investment.
If you invert P/E ratio, we get E/P ratio, which is the yield on our investment.
In this case, a P/E of 5 is equal to a yield of 20%.
P/E ratio is convenient and very easy to use. But that is why so many investors misuse it. Here are some common misuses of P/E ratio:
Using trailing P/E. Trailing P/E is the price earnings ratio of a company for the last 12 months.
For cyclical companies coming off a peak in earning, P/E ratio is misleading.
Trailing P/E ratio may look low but its forward P/E may not.
Forward P/E is calculated by using the predicted earnings per share of a company.
Forward P/E is more important than trailing P/E. After all, it is the future that counts.
Neglecting Earning growth. Low P/E ratio does not necessarily mean the stock is undervalued. Investors need to take into accounts the growth rate of a company.
Company A with a P/E ratio of 15 and 0% earnings growth may not look as appealing as company B with a P/E ratio of 20 and 25% earnings growth.
The reason is if both stock prices remain the same, after 3 years, P/E ratio of company B will decrease to 10.3 while A will still have a P/E ratio of 15.
The moral of the story here is to not use P/E ratio alone to judge the value of an asset.
Ignoring One-Time Event. P/E ratio always includes one-time event such as restructuring cost or downwards adjustments in goodwill.
When that happens, the ‘E’ in P/E ratio will appear low. As a result, this event inflates P/E ratio. Investors will do well ignoring this one-time event and look beyond the high P/E ratio.
Ignoring Balance Sheet. That is right. Investors often neglect the cash and long term debt embedded in the balance sheet when calculating P/E ratio.
The truth is, companies with higher net cash in their balance sheet usually get higher P/E valuation.
Ignoring Interest Rate. Using solely P/E ratio for our investing decision will yield disastrous results. As explained earlier, when we invert P/E ratio, we get E/P ratio.
E/P ratio is essentially the yield of our investment.
A stock with P/E of 10 is yielding 10%. Stock with P/E of 20 is yielding 5% and so forth.
If interest rate rises to 6%, then stocks that are trading at P/E of 20 will become overvalued, all else remains equal.
As with other financial ratios, P/E ratio cannot be solely used to value a company.
Interest rate fluctuates, earning per share goes up and down and so does stock price.
All these should be taken into consideration when choosing your potential investment.