Pitfalls of the P/E Ratio

One of the most common metrics used to gauge a stock's value is its price-to-earnings (P/E) ratio. It's the multiple of earnings you're willing to pay for a business -- the current price divided by the company's earnings per share. It's a good way to get a rough idea of whether a stock is cheap or expensive, but Fools shouldn't rely entirely on the P/E for their value assessments.

How the P/E works
Amazon.com
(Nasdaq: AMZN  ) has a P/E ratio of about 50, implying that investors are currently willing to pay $50 for every dollar of earnings Amazon generates. Similarly, Best Buy's (NYSE: BBY  ) P/E ratio of around 14.5 implies that investors are currently willing to pay $14.50 for each buck the electronics retailer makes.

For a different perspective, try flipping the P/E ratio to an E/P ratio, commonly referred to as the earnings yield. Like a yield on a bond, this number shows a company's annual earnings as a proportion of its market value. Buying one share of Amazon at $77, with EPS of $1.56, equates to an earnings yield of approximately 2% ($1.56 divided by $77). For Best Buy, the earnings yield is 6.8%, because each share of Best Buy stock, currently trading around $35, is expected to generate $2.39 in earnings per share. In the long run, Best Buy investors theoretically should earn a better rate of return than Amazon investors for each dollar invested.

Yet over the past three years, Best Buy has seen its stock lose an average of 11% annually, while Amazon's stock has jumped 29% per year. Of course, this is a very extreme, and to some degree unfair, comparison, since the two companies have very different business models. It's an apples-to-oranges comparison between an online retailer versus a big-box store. Like Amazon, Best Buy's stock-price performance was downright astonishing during its early years. So, what gives?

Avoid the pitfalls
Does the difference in P/E ratios alone make one company a better investment than the other? Not really. Although useful, P/E ratios have limitations. Yet investors tend to rely excessively on this one variable in determining an investment's attractiveness.

Most investors tend to agree that in general, businesses with lower P/E ratios tend to outperform high-P/E-ratio companies in the long run. However, that premise alone does not imply that all companies sporting single-digit ratios are superior investments. Just look at Citigroup (NYSE: C  ) over the past couple of years. Before the financial crisis hammered the company, Citigroup tended to have P/E ratios in the low teens. But those who bought in then are now sitting on big losses. At best, Citigroup faces an uncertain future, and its P/E ratio won't mean much for the foreseeable future.

Quality, not quantity
Fundamental problems exist with the P/E ratio. First, the "P" only refers to the equity price of a business; it doesn't consider debt. That's fine for companies without debt, like Apple (Nasdaq: AAPL  ) or Research In Motion (Nasdaq: RIMM  ) , but it's meaningless when there is debt involved. For instance, a business with a market cap of $5 billion, with $1 billion of net debt on the balance sheet, has an economic (or enterprise) value of $6 billion. If this company earns $500 million in profit in a given year, the P/E ratio would be 10, but in reality, investors should see it as 12. That can make a big difference in companies with huge amounts of debt, such as General Motors (NYSE: GM  ) and Ford (NYSE: F  ) .

The "E," or the per-share net income of a company, also poses problems. Creative accounting decisions, such as changing depreciation schedules or including non-recurring gains at certain points in time, can manipulate this figure. We all know that management has a considerable incentive to meet earnings expectations, so you should always examine earnings with a healthy dose of skepticism.

Most investors employ a host of investment considerations when assessing the value of a business. While the P/E ratio is a very useful resource, its often-ignored limitations can sometimes catch smart investors off guard. Use it carefully and prudently, and you'll be a lot less likely to fall into costly situations.

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This article, written by Sham Gad, was originally published on Dec. 5, 2007. It has been updated by Dan Caplinger, who doesn't own shares of the companies mentioned. Apple, Amazon.com, and Best Buy are Motley Fool Stock Advisor picks. The Fool owns shares of Best Buy, which is also a Motley Fool Inside Value selection. Try any of our Foolish newsletters today, free for 30 days. The Fool has a priceless disclosure policy.


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  • Report this Comment On May 29, 2009, at 12:27 PM, imalost wrote:

    Thats the argument that was made in 2000, we know how things turned out. Amazon is way overvalued, look at the other metrics and its the same. Hype, hype and hype this stock, You probably liked JDSU at $800 in 2000 and thought that PE didn't matter. You are in love with this stock and look at everything with rose color glasses, but any level headed person will tell you the current PE and price for this stock is ridiculous. But for some reason you come out every day and pump and hype this stock like no other, if you have a conflict of interest you should disclose it. Because nobody pumps this stock more than you fools.

  • Report this Comment On May 29, 2009, at 2:37 PM, latinpicker wrote:

    I Don't agree with the last part. The E is AFTER interest, so the debt remuneration is already taken care of.

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