Price Earning (P/E) Ratio is the most widely used ratio in investing. Searching the term ‘P/E ratio’ into Google will yield 2.3 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 $ 2.00 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/E. Trailing 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 10.3 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.

Source by Hari Wibowo

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