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. Generally speaking, a high P/E ratio may suggest that investors are expecting higher earnings growth in the future compared to those companies with a lower P/E. Basically, the P/E ratio indicates the dollar amount an investor can expect to invest in a company so that they may receive one dollar of that company’s earnings. While the P/E ratio is a useful stock valuation measure, it can be misleading to investors.
The P/E Ratio Can Mislead Investors
One reason why it's considered misleading for investors 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. Additionally, accounting techniques can control (or manipulate) financial reports.
This means that EPS can be skewed, depending on how the books are done. It 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.
There's More Than One Way to Calculate EPS
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, whether the data is from the past twelve months or estimates for the coming year. Analysts can use earnings estimates for determining what the relative value of a company will be at a future level of earnings – a value known as the forward P/E.
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 primary limitation of using P/E ratios comes about when investors compare P/E ratios of different companies. Valuations and business models may vary wildly across sectors and its best to use P/E as a comparative tool for stocks within the same sector rather than multiple different sectors.
An Example of a P/E Ratio Comparison Between Stocks
A quick look at P/E ratios for Apple (AAPL) and Amazon (AMZN) illustrates the dangers of using only the P/E ratio to evaluate a company. In mid-December, 2018, Apple traded at $165.48 with a P/E ratio (TTM) of 13.89. On the same day, Amazon’s stock price was $1,591.91 with a P/E ratio of 89.19. One of the reasons Amazon’s P/E is so much higher than Apple's is that its efforts to expand aggressively on a wide-scale have helped keep earnings somewhat suppressed and the P/E ratio very high.
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.