Problems with the P/E Ratio and Tips for How to Use it Correctly

The price-to-earnings ratio is one of the most used fundamental metrics in the analysis of stocks and securities. Most often shortened to P/E ratio it is a benchmark of describing how cheap or how expensive a stock is in regards to value. The ratio is acquired by dividing the current price (P) by the earnings per share (EPS). A higher P/E ratio signifies an investor would be paying a higher amount for each unit of net income whereas a lower P/E ratio is just the opposite.

Each one is often easily described as cheap or expensive respectively.

Although hallmarks of the investing world like value investors Warren Buffet, Benjamin Graham, Jeremy Siegal et al. have praised its use, the use of the P/E ratio at the expense of other metrics may leave investors missing big holes in a stock they thought was worth buying.

Perhaps worse, they may miss out on the next big home run stock because they are worried about value.

As we continue this series we will look at other methods of determining value.

Criticisms of the P/E Ratio

Is the Price reflecting the Value of the Company?

One obvious criticism of the use of the P/E ratio that affects an investor’s decision is the current price of the stock. As we stated earlier the P/E ratio is using the current price (P) as the first variable when deciding the value of the underlying security. But what if that variable is wrong? Does the current market price necessarily reflect the value of the company accurately?

Stock prices can be dictated by so many different variables and it is hard to argue that many of them accurately portray the health or profitability of a company. Such things as commodities, presidential elections and environmental disasters which have seemingly no relation on a specific security, can bring it tumbling or skyrocketing. We see this on a daily basis with the rise and fall of the major indexes.

Are the Earnings truly Accurate of the Value of the Company?

We hear all the time about schemes in which companies ‘cook the books’ or fictitiously make earnings and revenue appear much better than they are. However these blatant forms of fraud are hardly that regular with any given stock the average investor might buy, save for penny stocks. Nevertheless there are still incidents in which a company may be able to truthfully hide failure or manipulate success to appear better than average. Obviously it’s in their best interest to do so, so why not?

Zacks does an incredible job of describing two common ways in which a company can disguise the numbers. One is by taking out the defined pension plans which appear as an expense in the quarterly reports. Of course, they still exist and are paid regardless but will now be pushed to another quarter’s fillings, perhaps one in which they were heavily profitable and could afford another expense on the books.

Another option is that a company could assume the depreciation of assets is working at a decelerating rate or that they will receive a larger percentage of their original worth back when it comes time to dispose of them. Assets can really be anything from physical land, equipment, machines to things like employees and even brands or names.

By being more optimistic about these returns quarterly results will appear more profitable. Eventually those assets will need to be replaced, repaired or removed and a cost will come

In periods of inflation or deflation the value of assets can rise or fall at no fault to the company.

P/E Ratio Expectations are Different in Each Industry

It may come as a surprise but what is considered a desirable P/E ratio can be incredibly different between industries, sectors and even countries.

Companies with much slower growth like those in the non-discretionary goods, transportation, utilities, etc. are often upheld as great values when their P/E ratio is closer to 10-15.

In stark contrast many investors will be willing to pay 20-30 times current earnings per share as a result of high growth prospects. This is most common in the technology sector but also present in biomedical and discretionary goods.

How you can use the P/E ratio accurately

The right way to use the P/E ratio as a tool in selecting stocks or doing your research is as a way to save time. The P/E ratio favors simplicity and offers an excellent opportunity for an investor to make their way through thousands of stocks and find a handful at a time to look at.

Because I am a value investor more often than not, I rarely chase high growth stocks. As a result I am constantly on the lookout for stocks with low P/E ratios. When I find a group that I like I then look at them on an individual basis using the criticisms outlined above to test whether or not I should invest in a given stock.

You will not be able to find the answer for all of those questions and that is fine. The P/E ratio is just a tool to try to make you better investments and minimize your risk. Nothing will work perfectly and with each stock you find that has an attractive P/E ratio there are likely problems with it that are unseen.

Tips for Using the P/E Ratio to Find a Great Stock… or determining which ones are losers

• Use a Stock Screener  – I love the one at  Finviz. Search whatever metric you like such as sector or price and with each listing comes the current P/E ratio. No Math required.
• Check it out each Quarter – Because the P/E ratio changes daily and throughout the day based on the markets price begin looking at many days and take averages. One day might be a fluke that could prevent or inhibit you from making a decision.
• Pay attention to the Overall Market – There are times when the market will affect almost every stock regardless of the lack of connection. Nevertheless this will have an exaggerated outlook on the P/E ratio.
• What about the Company? – If the P/E ratio looks great but the company stinks it still stinks. Why bother investing? Just as an attractive company that has a high P/E ratio is worth it because the fundamentals look promising for the future.