The price-to-earnings ratio (P/E) is a fairly simple tool for assessing company value. Judging by how often the P/E ratio gets touted - by Wall Street analysts, the financial media and colleagues at the office water cooler - it's tempting to think it's a fool-proof tool for making wise stock investment choices. Think again; the P/E ratio is not always reliable. There are plenty of reasons to be wary of P/E-based stock valuations.
Tutorial: Financial Ratios
Calculating the P/E ratio - Quick Review
On the surface, calculating the price-to-earnings is fairly straightforward. The first step in generating a P/E ratio is to calculate earnings per share or EPS. Typically, EPS equals the company's after tax profits divided by the number of shares in issue
EPS = Post-Tax Profits / Number of Shares
From the EPS, we can calculate the P/E ratio. The P/E ratio equals the company's current market share price divided by the earnings per share for the previous year.
P/E = Share Price / EPS
The P/E ratio is supposed to tells investors how many years' worth of current earnings a company will need to produce in order to arrive at its current market share value. So, let's say the imaginary company Widget Corp. earned $1 per share over the past year and it's trading at $10.00 per share. The P/E ratio would be $10/$1 = 10. What this tells us is that the market prices it at 10 times earnings. Or in other words, for every share purchased, it will take 10 years of cumulative earnings to equate to the current share price. Naturally, investors want to be able to buy more earnings for every dollar they pay, so the lower the P/E ratio, the less expensive the stock.
The ratio sound simple enough, but let's look at some of the dangers associated with taking P/E ratios at face value.
The first part of the P/E equation - price - is straightforward. We can be fairly confident what the market price is. On the other hand, coming up with an appropriate earnings number can be tricky. You have to make a lot of decisions how to define earnings.
What's in those Earnings?
For starters, earnings aren't always clear cut. Earnings can be affected by unusual gains or losses which sometimes obscure the true nature of the earnings metric. What's more, reported earnings can be manipulated by company management to meet earnings expectations, while creative accounting choices - shifting depreciation policies or adding or subtracting non-recurring gains and expenses - can make bottom line earnings numbers bigger and, in turn, P/E ratios, smaller and the stock appear less expensive. Investors need to be wary of how companies arrive at their reported EPS numbers. Appropriate adjustments often have to be done in order to obtain a more accurate measure of earnings than what is reported on the balance sheet.
Located right in the company's latest published income statement, historic earnings are easy to find. Unfortunately, they are not much use for investors, since they say very little about what earnings are in store for the year and years ahead. It's the company's future earnings that investors are interested in most since as they reflect a stock's future prospects.
Forward earnings (also called future earnings) are based on the opinions of Wall Street analysts. Analysts, if anything, typically tend to be over-optimistic in their assumptions and educated guesses. At the end of the day, forward earnings suffer the problem of being a lot more useful than historic earnings but prone to inaccuracies.
What about Growth?
The biggest limitation of the P/E ratio: it tells investors next-to-nothing about the company's EPS growth prospects. If the company is growing quickly, you will be comfortable buying it even it had a high P/E ratio, knowing that growth in EPS will bring the P/E back down to a lower level. If it isn't growing quickly, you might shop around for a stock with a lower P/E ratio. It is often difficult to tell if a high P/E multiple is the result of expected growth or if the stock is simply overvalued.
A P/E ratio, even one calculated using a forward earnings estimate, doesn't always tell you whether or not the P/E is appropriate to the company's forecasted growth rate. So, to address this limitation, we turn to another ratio, the PEG ratio:
PEG = PE/forecast EPS growth rate over the next twelve months
In a nutshell, the lower the PEG ratio, the better. A PEG of one suggests that the P/E is in line with growth; below one implies that you are buying EPS growth for relatively little; a PEG greater than one could mean the stock is overpriced. However, even when the P/E ratio is standardized for growth, you are basing your investment decision on outside estimates, which may be wrong. (Learn how this simple calculation can help you determine a stock's earnings potential. Read PEG Ratio Nails Down Value Stocks.)
What about Debt?
Finally, there's the tricky issue of a company's debt load. The P/E ratio does nothing to factor in the amount of debt that a company carries on its balance sheet. Debt levels have an impact on financial performance and valuation, yet the P/E doesn't allow investors to make apples-to-apples comparisons between debt-free firms and those bogged down with outstanding loans and liabilities.
One way to address this limitation is to consider a company's enterprise value or EV in place of its Price or P.
(simplified) EV = Market Capitalization + Net Debt
Let's say the Widget Corp., with a market share price of $10 per share, also carried the equivalent of $3 per share of net debt on its balance sheet. The company, then, would have total enterprise value of $13 per share. If Widget Corp. produced EPS this year of $1, its P/E ratio would be 10. But more sophisticated investors would perform the calculation with enterprise value in the numerator and EBITDA in the denominator.
The Bottom Line
Sure, the P/E ratio is popular and easy to calculate. But it has big shortcomings that investors need to consider when using it to assess stock values. Use it carefully. No single ratio can tell you all you need to know about a stock. Be sure to use a variety of ratios to get a fuller picture of financial performance and stock valuation.
Fundamental AnalysisThe P/E ratio is one of the most popular stock market ratios, but it has some serious flaws that investors should know about.
Investing BasicsIf these numbers have you in the dark, these easy calculations should help light the way.
Forex EducationWhile the price-to-earnings ratio is commonly used for assessing stock prices, the price/earnings-to-growth ratio offers forecasting advantages that investors need to know.
Charts & PatternsSquare is reported to have filed for an IPO. For interested investors wondering how the company makes money, Investopedia takes a look at its business.
Technical IndicatorsThinking of trading in risky penny stocks? Use this checklist to find bargains, not scams.
ProfessionalsThe Chinese economy's ongoing slowdown is having a major impact on iron ore demand.
Investing BasicsObtain a better understanding of the debt/equity ratio, and learn why this fundamental financial metric varies significantly between industries.
Credit & LoansA nonperforming loan is any borrowed sum where the borrower has failed to pay scheduled payments for at least 90 days.
EconomicsThe cost of revenue is the total costs a business incurs to manufacture and deliver a product or service.
EconomicsCash and cash equivalents are items that are either physical currency or liquid investments that can be immediately converted into cash.
A company's total revenue (equivalent to total sales) minus the ...
An accounting measure used to quantify a firm's effectiveness ...
A set of international accounting standards stating how particular ...
The amount of money that a company actually receives during a ...
A financial statement that summarizes a company's assets, liabilities ...
The value of an asset less the value of all liabilities on that ...
The compound annual growth rate, or CAGR for short, measures the return on an investment over a certain period of time. Below ... Read Full Answer >>
In accounting, general and administrative expenses represent the necessary costs to maintain a company's daily operations ... Read Full Answer >>
Since the fixed charge coverage ratio indicates the number of times a company is capable of making its fixed charge payments ... Read Full Answer >>
Return on total assets (ROTA) represents one of the profitability metrics. It is calculated by taking a company's earnings ... Read Full Answer >>
Because they provide different perspectives of analysis, the EV/EBITDA multiple and the P/E ratio can be used together to ... Read Full Answer >>
Small business owners should go through the bank reconciliation process at least monthly, and many business consultants recommend ... Read Full Answer >>