Two Reasons to Be Cautious About P/E Ratios

Be Cautious Of Using Price To Earnings Ratios To Value Individual Stocks

The PE ratio is not alpha, the golden ratio of risk adjusted return.
Be careful about using P/E ratios - they may lead you to make a bad investment decision. Dominique Sarraute / Getty Images

Price to earnings (P/E) ratios can be moderately useful when looking at the stock market as a whole, or when looking at an individual stock. But be cautious when using P/E to make a final determination on the value of a company. The caution stems from the unknown future of "E".

  • The "P" is the stock price. This figure can be found online easily.
  • The "E" in P/E ratio stands for "earnings".

The "E" is tricky though, as it can be based on past earnings which are a known thing, or the "E" can be an estimate based on projected earnings, which are an unknown thing.

We all know reality does not always turn out the way we project it will.

With either of those two P/E models there is a reason to be cautious.

Two Things to Consider When Looking at a P/E Ratio

Here are two things to be cautious about when it comes to the earnings part of the formula.

1. Price to earnings ratios based on past data. There is no guarantee the company’s products will continue to sell in the future as well as they have in the past. Earnings can change. Past earnings is not always a reliable indicator of future earnings.

2. Price to earnings ratios based on projected earnings. Analysts study past data to identify consumer trends and develop projections, but consumers are fickle, and new products can easily change buying habits. Future earnings are not predictable.

The following examples show you how using the price to earnings ratio to determine the expected value of an individual stock can lead you to a bad investment decision.

Calculating price to earnings (P/E) ratios

WIDGET Company

Here are the facts:

  • The stock is selling at $20 per share.
  • Last year, WIDGET had earnings of $1 per share.
  • Analysts estimate the company will earn $2 per share this year.
  • P/E ratio based on past earnings is 20. Calculation: $20/$1 = 20.
  • P/E ratio based on projected earnings is 10. Calculation: $20/$2 = 10.

    This means you are willing to pay $10 for every dollar of projected earnings. This is also referred to as paying “10x” earnings, or the stock is said to have "an earnings multiple of 10".

    GZMO Company

    Here are the facts:

    • GZMO is trading at $10 per share.
    • Last year GZMO had earnings of $.50 per share.
    • Analysts estimate the company will earn $.60 per share this year.
    • P/E ratio based on past earnings is 20. Calculation: $10/$.50 = 20.
    • P/E ratio based on projected earnings is 16.67. Calculation: $10/$.60 = 16.67.

    This means you are willing to pay $16.67 for every dollar of projected earnings. This is also referred to as paying “16.67x” earnings, or the stock is said to have "an earnings multiple of 16.67".

    Comparing P/E Ratios

    In comparison to WDGT, GZMO appears to be more expensive, as you have to pay more today for the same amount of expected future earnings.

    You buy WDGT.

    A few months after you buy WDGT, someone files a lawsuit naming one of WDGT’s well known products as a problem. People stop buying this product, and WDGT’s earnings go down. The stock price goes down too.

    GZMO, on the other hand, releases a new product that starts selling like hotcakes. GZMO’s earnings go up, and so does the stock price.

    Now WDGT is at $15 per share with $1.50 of earnings per share. It now has a P/E of 10.

    GZMO is selling at $15 per share with $.75 of earnings per share. It now has a P/E of 20.

    You decide that GZMO is growing faster, so you sell WDGT, realize your $5 per share loss, and buy GZMO.

    A year later, WDGT’s lawsuit gets dismissed. GZMO’s product, although popular, was a quick fad, and they had no more new products in the production line.

    WDGT’s stock steadily climbs to $25 per share. Their earnings rise to $2.25.

    GZMO’s stock drops to $9 per share. Their earnings go back to $.50.

    The bottom line

    Because of constant changes, as described in the above examples, price to earnings ratios should not be used as a the only factor to determine if an individual stock is appropriately valued. No one knows the future, and a ration cannot tell you what the future may bring.

    There are many other factors that should go into picking a stock to invest in.