5 Common 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 yield
23 million results Quite simply, P/E ratio is the ratio of
Stock price divided by its Earning per Share (EPS) If a company
A is trading at $ 10 per share and it earns $ 200 per share,
then A has P/E ratio of 5 This means 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 yield on
our investment In this case, a P/E of 5 is equal to a yield of
20%
P/E ratio is convenient and very easy to use But that is why so
many investors misuse it Here are some common misuse of P/E
ratio:
Using trailing P/ETrailing 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 predicted earning per
share 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 means 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
appealing as company B with a P/E ratio of 20 and 25% earning
growth The reason is if both stock prices remain the same,
after 3 years, P/E ratio of company B will decrease to 103
while A will still have a P/E ratio of 15 The moral of the
story here is to not use P/E ratio alone to judge 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 result, 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 embedded 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 yield disastrous results As explained
earlier, when we invert P/E ratio, we get E/P ratio E/P ratio
is essentially the yield 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 share
goes up and down and so does stock price All these should be
taken into consideration when choosing your potential investment

Tags | balance, earnings, event, goodwill, initial, investment, investors, moral, price, prices, restructuring, result, sheet, stock, story