How can the price-to-earnings (P/E) ratio mislead investors?

By Jean Folger AAA
A:

The price-to-earnings (P/E) ratio is calculated by dividing a company’s stock price per share by its earnings per share (EPS), giving investors an idea of whether a stock is under- or overvalued. While the P/E ratio is a useful stock valuation measure, it can be misleading to investors. One reason is that a P/E ratio based on past data (as is the case with trailing P/E), does not guarantee earnings will remain the same. Likewise, if the P/E ratio is based on projected earnings (for example, with a forward P/E), there is no guarantee that estimates will be accurate. And, accounting techniques can control (or manipulate) financial reports. EPS, therefore, can be skewed, depending on how the books are done. This can make it difficult for investors to accurately value a single company or compare various companies since it may be impossible to know if they are comparing similar figures.

Another problem is that there is more than one way to calculate EPS. In the P/E ratio calculation, the stock price per share is set by the market. The EPS value, however, varies depending on the earnings data used; for example, data from the past twelve months or estimates for the coming year. Comparing one company’s P/E ratio based on trailing earnings to another’s forward earnings creates an apples-to-oranges comparison that can be misleading to investors. For these reasons, it is recommended that investors use more than the P/E ratio when evaluating a company or comparing various companies.

A quick look at P/E ratios for Apple Inc (AAPL) and Amazon.com Inc (AMZN) illustrates the dangers in using only the P/E ratio to evaluate a company. Apple was traded at $92.18 with a P/E ratio (TTM) of 15.34. On the same day, Amazon’s stock price was $334.38 with a P/E ratio of 511.06. One of the reasons Amazon’s P/E is so high is that it always reinvests its earnings. If you were to compare these two stocks based on P/E alone, it would be impossible to make a reasonable evaluation. A low P/E ratio doesn’t automatically mean a stock is undervalued, just like a high P/E ratio doesn’t necessarily mean it is overvalued.

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