5 Common Misuse of P/E Ratio
Price Earning (P/E) Ratio is the most widely used ratio in
investing. Searching the term 'P/E ratio' into Google will yield
2.3 million results. Quite simply, P/E ratio is the ratio of
Stock price divided by its Earning per Share (EPS). If a company
A is trading at $ 10 per share and it earns $ 2.00 per share,
then A has P/E ratio of 5. This means that it takes 5 years for
the company's earnings to pay up for your initial investment. If
you invert P/E ratio, we get E/P ratio, which is the yield on
our investment. In this case, a P/E of 5 is equal to a yield of
20%.
P/E ratio is convenient and very easy to use. But that is why so
many investors misuse it. Here are some common misuse of P/E
ratio:
Using trailing P/E.Trailing P/E is the price earning
ratio of a company for the last 12 months. For cyclical
companies coming off a peak in earning, P/E ratio is misleading.
Trailing P/E ratio may look low but its forward P/E may not.
Forward P/E is calculated by using the predicted earning per
share of a company. Forward P/E is more important than trailing
P/E. After all, it is the future that counts.
Neglecting Earning growth. Low P/E ratio does not
necessarily means the stock is undervalued. Investors need to
take into accounts the growth rate of a company. Company A with
a P/E ratio of 15 and 0% earning growth may not look as
appealing as company B with a P/E ratio of 20 and 25% earning
growth. The reason is if both stock prices remain the same,
after 3 years, P/E ratio of company B will decrease to 10.3
while A will still have a P/E ratio of 15. The moral of the
story here is to not use P/E ratio alone to judge the value of
an asset.
Ignoring One-Time Event. P/E ratio always includes
one-time event such as restructuring cost or downwards
adjustments in goodwill. When that happens, the 'E' in P/E ratio
will appear low. As a result, this event inflates P/E ratio.
Investors will do well ignoring this one-time event and look
beyond the high P/E ratio.
Ignoring Balance Sheet. That is right. Investors often
neglect the cash and long term debt embedded in the balance
sheet when calculating P/E ratio. The truth is, companies with
higher net cash in their balance sheet usually get higher P/E
valuation.
Ignoring Interest Rate. Using solely P/E ratio for our
investing decision will yield disastrous results. As explained
earlier, when we invert P/E ratio, we get E/P ratio. E/P ratio
is essentially the yield of our investment. A stock with P/E of
10 is yielding 10%. Stock with P/E of 20 is yielding 5% and so
forth. If interest rate rises to 6%, then stocks that are
trading at P/E of 20 will become overvalued, all else remains
equal.
As with other financial ratios, P/E ratio cannot be solely used
to value a company. Interest rate fluctuates, earning per share
goes up and down and so does stock price. All these should be
taken into consideration when choosing your potential investment.