Learning the Limits of the Price Earnings Ratio

As most investors know, the Price/Earnings (P/E) ratio has the reputation as one of the most fundamental metrics for expressing a stock’s value. There’s nothing wrong with using this classic metric as a back-of-the-envelope method for comparing a stock’s price to its profitability. But we urge investors to avoid the trap of thinking of P/E ratio as a failsafe measure of a company’s market worth.

First, the metric has always had some fundamental limitations. Second, the evolving nature of modern business, coupled with accounting rules rooted in the mid-20th century, renders the ratio a hazier measure than ever before.

  1. A snapshot of data: the P/E/ ratio compares a stock’s current price to its current earnings (typically the trailing 12 months). Earnings vary wildly in many sectors, however, even for the most successful firms—and the P/E ratio doesn’t take even recent historical data into account.
  2. Growth agnostic: the P/E ratio ignores earnings growth information that may already be public knowledge. At some level this fact is a feature: the whole point of a simple, clean metric like this is to get away from uncertainties like earnings projections. That said, if we’re talking about valuing a stock, the P/E ratio is simply not taking into account much of the available data.
  3. Balance sheet blues: when analyzing a stock, it’s vital to always consider not only “flows” (revenues and cost) but “stocks” (debts and assets). Once again, the P/E ratio has no way of expressing, for instance, a company that’s juicing earnings by piling on debt.

More fundamentally, the changing nature of enterprise in a largely digital economy with many service industry firms makes interpreting the meaning of an earnings snapshot more ambiguous than ever before. Huge swaths of, for instance, the pharmaceutical and software industry have business models dedicated to developing intellectual property. This IP very well may have close to zero current earning power until the day it’s purchased by another firm or otherwise commercialized. And, in situations like these, P/E ratio is of close to zero analytical value. Other firms, like oil-gas exploration companies, acquire mineral rights with a purely prospective value that won’t be expressed in current earnings in any way—again, not a great target for this metric.

Key tips for making use of this handy metric without letting it mislead your analysis include:

  1. Be careful making inter-industry comparisons: direct P/E ratio comparisons are most likely to valid within the same industry. Comparing them between firms in different industries without further research would be profoundly misleading.
  2. Remember that Earnings are Different for “Growth” Stage Companies: Back in the 1930’s, the legendary value investor Benjamin Graham (who is largely responsible for popularizing the metric) suggested a P/E ratio around 16 as a conservative upper end for a well-valued company. Amazon, meanwhile, recently traded at P/E ratios above 350. Remember that a rapidly growing company should be reinvesting its revenues—an added cost today—to maximize forward-looking earnings growth.
  3. Ask “Why?”: Remember that this metric is publicly viewable information, one of the first indicators other market players are likely to glance at when making a decision on a stock. A strange P/E ratio (at either end of the spectrum) isn’t’ a reason to cast a stock aside—just an opportunity for further research. If a stock has an attractive P/E ratio, ask what’s making other investors stay away. If a stock’s P/E ratio is sky high, ask why other investors are willing to own shares at such a premium to current earnings. Exploring counterintuitive metrics is a great way to teach yourself the subtleties of different market segments.

Ultimately, the P/E ratio is still a very useful tool. But it’s always just one piece of the puzzle. To learn more about completing the puzzle with real-time data and news analytics, we recommend one of our totally free virtual training sessions. We go over some fundamentals of data-based trading and take a look at how our platform finally makes this dynamic trading approach accessible to smaller investors (hedge funds have been cashing in for years).  You can sign up using the button below:

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