Why the P/E Ratio Is Dangerous

I have no doubt that the most widely used valuation tool by individual investors is the price-to-earnings ratio (P/E). Unfortunately, it may also be the most dangerous tool, because it's so misunderstood. Today, I'll talk (well, type) a little about what the P/E's problems are and how you can overcome them.

What it is
On the surface, this is a very simple and informative ratio -- a company's stock price divided by its last 12 months of earnings per share. So we can look and see that Monsanto earned $4.10 per share over the past year. At today's price around $81.30, its P/E ratio is $81.30 / $4.10 = 20. You might also hear the hip Wall Street crowd say "Monsanto has a multiple of 20" -- because it sounds so cool.

Because you obviously want more earnings for every dollar you invest, a lower P/E is considered more attractive. After all, you'd rather be paying $40.65 per share for Monsanto's $4.10 in earnings (P/E = 10) than $81.30 (P/E = 20), right?

Yes, absolutely -- why wouldn't you want to pay less for the exact same earnings stream? The same principle also applies when comparing different businesses, as long as they are equal in all other respects.

What it isn't
Of course, things are never equal in the investing world (you didn't need me to tell you that), and this is where problems creep in. It's also why the P/E ratio should never be the only tool you use to value a business, for several reasons. Let's look at three of them.

1. Forward to the future
A glance at most any financial data provider tells us that Cisco Systems (Nasdaq: CSCO  ) is trading at a P/E of 16. Juniper Networks (Nasdaq: JNPR  ) has a multiple of 31. So Cisco must be a better value, right?

Well … maybe. It's rare to find two businesses that are exactly alike, and these two certainly have their differences. Also, analysts estimate Juniper will grow earnings about 18% annually over the next five years, while Cisco is only projected to grow at around 10% per year. So there you run into a big problem with the P/E -- it's a short-sighted, usually backward-looking tool. If one company is able to double its earnings in a few short years while another remains stagnant, the former could be a much better value despite a higher multiple. Yet you wouldn't know it from the single-snapshot picture the P/E provides.

The "forward P/E" published by some sources is a better tool, because it uses the next year's estimated earnings for the "E" part of the equation, instead of the previous year's earnings. But that still provides only a very limited snapshot. This chart illustrates just how tough it is to get a handle on this simple ratio.

Company

Estimated 2-Year Growth Rate

Trailing P/E

Forward P/E*

Apollo Group (Nasdaq: APOL  )

69%

16

15

USEC (NYSE: USU  )

91%

17

15

Visa (NYSE: V  )

49%

41

20

Baidu.com (Nasdaq: BIDU  )

77%

65

44

Data provided by Capital IQ, a division of Standard & Poor's. *Using next 12 months' earnings estimate.

The first two companies look like bargains compared to their growth rates, but you should question just how likely they are to achieve this future growth. The second two appear expensive looking backward, but much more reasonable looking forward. But how much growth will there be after the next couple of years? So many variables!

2. Focus on fundamentals
As the previous example shows, the P/E becomes more useful if you can get a grasp on just how much in earnings a company will be able to achieve over the coming years. But in order to do this, you'll need to study the underlying business and understand its margins, scalability, competitive position within the industry, etc. This fundamental analysis goes a long way toward putting the P/E in its proper perspective.

3. The fiction of accounting
Another problem comes in defining "earnings," the denominator in our equation. Like Donald Trump's hair color, it isn't always what it seems. In fact, unlike Donald's hair, it's so easy to massage and manipulate the earnings number that it's a wonder the Street still hangs on every penny. While one company may report a largely honest number, its competitor may be padding the EPS in order to "meet estimates." In the end, stuff like that usually catches up to these companies -- and, in turn, their shareholders.

My story
The best way to think about the P/E ratio reinforces what Motley Fool co-founders Tom and David Gardner tell members of their Stock Advisor investing service: You must understand that you're buying a business when you buy a stock. I'd heard that often enough, but it took a real-life example to drive the point home.

Several years ago, a friend and I considered buying a sporting goods store. It was a family-run business, with virtually no debt -- or cash -- on the balance sheet. The owner wanted $100,000 for it.

What's the most important thing you'd want to know if you'd been in our situation? Right: how much money we could reasonably expect to earn over the next few years. We didn't care about the fiction of accounting earnings (point No. 3 above) -- we wanted to know how much in real cash profits the business could pull in.

If it were $10,000 per year, we'd be getting the company at a P/E of 10 ($100,000 / $10,000 = 10). If it were $5,000, that's a much less attractive multiple of 20.

We dived into the fundamental analysis to figure out the real earning power of the company (point No. 2). The short story is, we thought we could make the business much more efficient (improving the margins), but future revenue and earnings growth (point No. 1) seemed very limited due to several well-financed competitors in the area.

In assessing whether this was a smart purchase, we used the three points to come up with our decision. In the end, we passed on the purchase because the P/E we calculated was over 20. Using that number hand-in-hand with our analysis, we knew it would have taken too long for us to even recoup our original investment. But the exercise itself was a lesson I'll never forget.

The lesson
Using P/E as a standalone valuation tool could cost you big-time. Isolating on any single metric, for that matter, is a recipe for disaster.

When David recommended Amazon.com (Nasdaq: AMZN  ) in September 2002, he acknowledged that its P/E of 75 carried risks. But his fundamental analysis convinced him the company deserved that multiple, and the stock is up more than 400% since.

If you'd like a look at all of the Gardners’ recommendations, which are beating the market by an average of 40 percentage points each, consider a 30-day free trial. This also includes the top five stocks for new money now. For more information, click here.

Rex Moore is a Fool analyst who's been cleared to operate heavy machinery. He owns no companies mentioned in this article. Amazon.com is a Motley Fool Stock Advisor selection. Baidu is a Rule Breakers pick. The Fool has a disclosure policy.


Read/Post Comments (7) | Recommend This Article (57)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 26, 2009, at 3:00 PM, snakeflake wrote:

    Isnt that why you should calculate the PEG, to factor in growth? At that point you can compare apples to oranges.

  • Report this Comment On June 28, 2009, at 3:57 AM, wagnjohn wrote:

    All other things equal, the P/E ratio should vary positively with changes in expected earnings growth rate and negatively with changes in the discount rate, or opportunity cost of capital.

    A low P/E may signal that the company is going out of business and liquidating itself by giving high dividends to make up for expected loss of market capitalization.

    I consider an abnormally low P/E ratio to be a red flag signaling the need to do rigorous due dilligence.

    All other things are never equal.

    Caveat emptor on the ceteris paribus!

  • Report this Comment On July 15, 2009, at 1:43 PM, ChannelDunlap wrote:

    In all fairness to P/E, I like it because it's definite. I know what people are paying right now for what we KNOW the company can make. There is far too much speculation in calculating PEG for me to see it as a very reliable indicator. Of course you wouldn't look exclusively at one or the other to make a decision, but I definitely give the P/E more weight in my considerations than the PEG. Just my two cents.

  • Report this Comment On July 15, 2009, at 2:14 PM, TimothyVR wrote:

    I have been reading about the importance of the P/E ratio in determining the potential bottom of a bear market. It is only in the last year that I have started becoming educated in the markets and investing in individual stocks.

    It's difficult to find data that a layman can grasp, so I appreciate this information.

  • Report this Comment On July 30, 2009, at 1:03 PM, nottheSEC wrote:

    Agreed!

    There was an recent Zacks article about the dangers of making magic numbers of under 20 P/E and under 1 P/B without considering the Industry (the article is below for its perusal).

    There any many metrics one must consider. I personally use the industry metric i.e in hotels REITS its REVPAR or revenue per available room, debt level, the PE as compared to its peers, sector market sentiment, navallier/msn/zacks/ opinion, technical analysis and finally my own social conscious metric. To each his own due diligence

    http://www.zacks.com/commentary/8092/%26%2339%3BMagic+Number...

    Disclosure: I wouldn't invest in USU if it were free because to MY opinion it isn't socially conscious BUT to EACH his/her OWN.Think about the uranium miners radation exposure when you consider that X- ray tech have been shown to have shorter life spans. While nuclear power recycles waste water now you still have to get rid of the 1/2 billion year isotopes eventually.

    MY nickle and opinion...J

  • Report this Comment On August 22, 2009, at 11:53 PM, BasicInvester wrote:

    This is a very useful article for a novice like me. Thanks!

  • Report this Comment On November 09, 2012, at 9:13 PM, balesmarcio wrote:

    E eu estou sabendo que tem muita traiçao por ai mas aqui eu estou ainda mais tendo a certeza

    paty

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