5 shared 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 provide 2.3 million results. Quite simply, P/E ratio is the ratio of Stock price divided by its Earning per proportion (EPS). If a company A is trading at $ 10 per proportion and it earns $ 2.00 per proportion, then A has P/E ratio of 5. This method 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 provide on our investment. In this case, a P/E of 5 is equal to a provide of 20%.
P/E ratio is functional and very easy to use. But that is why so many investors misuse it. Here are some shared 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 expected earning per proportion 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 method 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 alluring as company B with a P/E ratio of 20 and 25% earning growth. The reason is if both stock prices keep the same, after 3 years, P/E ratio of company B will decline to 10.3 while A will nevertheless have a P/E ratio of 15. The moral of the story here is to not use P/E ratio alone to estimate 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 consequence, 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 encased 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 provide disastrous results. As explained earlier, when we invert P/E ratio, we get E/P ratio. E/P ratio is essentially the provide 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 proportion goes up and down and so does stock price. All these should be taken into consideration when choosing your possible investment.