Don't Get Snared by False Values

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.

Today's stock market has plenty of traps for the unwary. Read why Jordan DiPietro thinks the current rally is doomed.

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. Google is a Motley Fool Rule Breakers pick. Amazon.com, Best Buy, and eBay are Motley Fool Stock Advisor recommendations. The Fool owns shares of Best Buy, which is a Motley Fool Inside Value selection. Motley Fool Options has recommended a bull call spread on eBay. Try any of our Foolish newsletters today, free for 30 days. The Fool has a priceless disclosure policy.


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