Common Misuse Of P/e Ratio

Price Earning (P/E) Ratio is the most widely used ratio in investing. Searching the term 'P/E ratio' into Google will yield . 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 $ per share and it earns $ . per share, then A has P/E ratio of . This means that it takes 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 is equal to a yield of %. 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 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 and % earning growth may not look as appealing as company B with a P/E ratio of and % earning growth. The reason is if both stock prices remain the same, after years, P/E ratio of company B will decrease to . while A will still have a P/E ratio of . 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 is yielding %. Stock with P/E of is yielding % and so forth. If interest rate rises to %, then stocks that are trading at P/E of 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.