The price-to-earnings ratio (P / E) is the ratio most commonly used in an investment. A search for ‘P / E ratio’ on Google will return 2.3 million results. Simply put, the P / E ratio is the ratio of the share price divided by its earnings per share (EPS). If Company A trades at $ 10 per share and earns $ 2.00 per share, then A has a P / E ratio of 5. This means that it takes five years for company earnings to pay off for your initial investment. If you reverse the P / E ratio, we get the E / P ratio, which represents the return on our investment. In this case, a P / E of 5 equals a yield of 20%.
The P / E ratio is convenient and very easy to use. But that’s why so many investors are abusing it. Here are some common abuses of the P / E relationship:
Use of accompanying P / E. The final P / E is the ratio of the company’s price earnings in the last 12 months. For cyclical companies that reach peak earnings, the P / E ratio is deceptive. The final P / E ratio may seem low, but its front P / E may not. The forward P / E is calculated using the projected earnings per company share. Forward P / E is more important than P / E at the threshold. Finally, the future counts.
Neglecting earnings growth. A low P / E ratio does not necessarily mean that the stock is undervalued. Investors must take into account the growth rate of the company. Company A with a P / E ratio of 15 and 0% earnings growth may not look as appealing as Company B with a P / E ratio of 20 and 25% earnings growth. The reason is if both stock prices remain the same, after 3 years, the 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 is not to use P Only ratio E to assess the value of the property.
Ignoring a one-time event. The P / E ratio always includes one-off events such as restructuring or downward adjustment costs in goodwill. When this happens, the ‘E’ in the P / E ratio will appear low. As a result, this event inflates the P / E ratio. Investors will well ignore this one-off event and look beyond the high P / E ratio.
Ignoring the balance sheet. It’s true. Investors often neglect cash and long-term debt embedded in the balance sheet when calculating the P / E ratio. It is true that companies with higher net cash in the balance sheet usually get a higher P / E estimate.
Neglect of interest rate. Using only the P / E ratio for our investment decision will yield disastrous results. As explained earlier, when we reverse the P / E ratio, we get the E / P ratio. The E / P ratio is basically the return on our investment. Shares with a P / E of 10 yield 10%. Stocks with a P / E of 20 give 5% and so on. If the interest rate rises to 6%, then shares traded at a P / E of 20 will become overvalued and everything else remains the same.
As with other financial indicators, the P / E ratio cannot be used only to value a company. Interest rates vary, earnings per share rise and fall, and so does the stock price. All this should be taken into account when choosing your potential investment.