

P/E Ratio: Problems With The P/E
So far we've learned that in the right circumstances, the P/E ratio can help us determine whether a company is over or undervalued. But P/E analysis is only valid in certain circumstances and it has its pitfalls. Some factors that can undermine the usefulness of the P/E ratio include:
Accounting
Earnings is an accounting figure that includes noncash items. Furthermore, the guidelines for determining earnings are governed by accounting rules (Generally Accepted Accounting Principles (GAAP)) that change over time and are different in each country. To complicate matters, EPS can be twisted, prodded and squeezed into various numbers depending on how you do the books. The result is that we often don't know whether we are comparing the same figures, or apples to oranges. (For more on this, see Different Types Of EPS.)
Inflation
In times of high inflation, inventory and depreciation costs tend to be understated because the replacement costs of goods and equipment rise with the general level of prices. Thus, P/E ratios tend to be lower during times of high inflation because the market sees earnings as artificially distorted upwards. As with all ratios, it's more valuable to look at the P/E over time in order to determine the trend. Inflation makes this difficult, as past information is less useful today.
Many Interpretations
A low P/E ratio does not necessarily mean that a company is undervalued. Rather, it could mean that the market believes the company is headed for trouble in the near future. Stocks that go down usually do so for a reason. It may be that a company has warned that earnings will come in lower than expected. This wouldn't be reflected in a trailing P/E ratio until earnings are actually released, during which time the company might look undervalued.



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How can the pricetoearnings (P/E) ratio mislead investors?
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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 Answer >> 
What is the average pricetoearnings ratio in the banking sector?
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What does the forward p/e indicate about a company?
Explore the forward price to earnings ratio and learn its significance and how it compares to the traditional price to earnings ... Read Answer >> 
How do I calculate the P/E ratio of a company?
Find out how to calculate this common valuation ratio and what the results can tell you about a company's performance. Read Answer >> 
Stocks with high P/E ratios can be overpriced. Is a stock with a lower P/E always ...
The short answer? No. The long answer? It depends.The pricetoearnings ratio (P/E ratio) is calculated as a stock's current ... Read Answer >>