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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 75, implying that investors are currently willing to pay $75 for every dollar of earnings Amazon generates. Similarly, Best Buy's (NYSE: BBY ) P/E ratio of around 19 implies that investors are currently willing to pay $19 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 $127, with EPS of $1.70, equates to an earnings yield of approximately 1.3% ($1.70 divided by $127). For Best Buy, the earnings yield is 5.5%, because each share of Best Buy stock, currently trading around $40, has generated $2.39 in earnings per share over the past year. 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 6.6% annually, while Amazon's stock has jumped 48% 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 Bank of America (NYSE: BAC ) over the past few years. Before the financial crisis hammered the company, B of A tended to have P/E ratios in the low teens. But those who bought in then are now sitting on big losses. Despite its recent rebound, B of A still 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 Google (Nasdaq: GOOG ) or eBay (Nasdaq: EBAY ) , 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 large amounts of debt, such as Ford Motor (NYSE: F ) and Deere (NYSE: DE ) .
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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