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.

  1. What does it mean when "N/A" appears for a company's P/E ratio?

    A "N/A" reported in a stock's price-to-earnings ratio (P/E), can mean one of two things. The first, and simplest, would be ... Read Full Answer >>
  2. Can a stock have a negative price-to-earnings (P/E) ratio?

    Yes, a stock can have a negative price-to-earnings ratio (P/E), but it is very unlikely that you will ever see it reported. ... Read Full Answer >>
  3. What's the difference between absolute P/E ratio and relative P/E ratio?

    The simple answer to this question is that absolute P/E, which is the most quoted of the two ratios, is the price of a stock ... Read Full Answer >>
  4. Can working capital be depreciated?

    Working capital as current assets cannot be depreciated the way long-term, fixed assets are. In accounting, depreciation ... Read Full Answer >>
  5. What does high working capital say about a company's financial prospects?

    If a company has high working capital, it has more than enough liquid funds to meet its short-term obligations. Working capital, ... Read Full Answer >>
  6. How can working capital affect a company's finances?

    Working capital, or total current assets minus total current liabilities, can affect a company's longer-term investment effectiveness ... Read Full Answer >>
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