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Investors continually use the price-to-earnings (P/E) ratio as a way to make a claim about an undervalued or overvalued stock. I continually cringe at the thought that investors will only look at the price-to-earnings ratio as a metric to invest. There’s so much more to a company and a stock beyond a P/E ratio and, in this article, you will learn why this popular valuation metric is not so important.
Not only this. A price-to-earnings ratio has a number of flaws that might actually mislead you in the wrong direction about a company. If I’m investing for the long-term, I want to build a portfolio of reliable stocks with attractive valuations, this can ensure you are well-positioned for compound interest over the long haul.
Let’s evaluate what we need to know about the price-to-earnings ratio before we get into the nitty-gritty details.
Why the PE ratio is not so important
The P/E ratio tells an investor what they are paying for every $1 of a company net income on a per-share basis. Net income is not necessarily cash flow. Also, a P/E ratio ignores a company’s balance sheet and capital structure as it pertains to your investment.
Thus, if you are looking at only the P/E ratio you are simply missing the bigger picture.
Additionally, I’ve been a bit frustrated with investors and their sole focus on applying a P/E ratio to a company and at the same time comparing that company with others in completely different industries. Do not do this. This is a great way to lose money in the stock market. Use a tool like Finbox to screen for, and find, attractively valued stocks. From there you can conduct diligence on their financial statements to make an investment decision.
Most Common Flaws with Using P/E Ratio as a Valuation Metric
Here are some of my favorite flaws with using P/E ratio to value a stock and make an investment decision.
1) Completely Ignores Capital Structure
I gave you a preview about this in my intro above. The P/E ratio only focuses on the perspective of equity investors. Thus, it completely ignores the consideration of debt. Earnings per share is after interest expense. Yes. However, if a company has multi-tranches of debt and upcoming principal repayment or balloon payments. You will completely miss the ball on the true financial standing of a company.
2) Earnings Per Share Isn’t (Always) Reliable
It might be a surprise to you, but earnings per share on a quarterly basis includes a lot of noise that might not represent the true operating performance of a company on a go-forward basis.
Well, there’s a number of reasons. Some include that management is compensated on the performance of earnings or compensated on via stock options. You can only get your stock options to vest by growing the stock price. A stock increases as a company grows earnings per share.
Larger companies tend to get judged on performance on a quarterly basis and management will have a number of adjustments to earnings per share to ensure the bottom doesn’t fall out of the stock price. You should remain critical on the true earnings per share of a company before using a P/E ratio to value a stock. Stock price is an objective measure. Earnings per share is not objective.
3) P/E Ratio Missed the Growth Picture
This is one of the biggest mistakes that investors make. A P/E ratio needs to be completely thrown out the window in the eyes of growth companies. An example of this is the eye of Tesla stock. This is a company that has grown revenue in excess of 50% per year (depending on the time frame you are looking at). Tesla is a company that only recently turned a profit and have years of opportunity to reduce operating expenses or achieve economies of scale.
Looking at Tesla’s P/E ratio and comparing it to other automotive stocks would be unfair to capture the true growth prospects of Tesla stock. Use a calculator to ensure you a buying a stock at the right initial price to correspond with the growth opportunities. Ensure you are compensated for your risk.
4) P/E Ratio is Not a One Size Fits All Approach
When in doubt, compare a company only to its peers. Why would you compare an apple to an orange? Investors frequently will say… “XYZ stock is undervalued because it is only trading at 8x P/E ratio.” Is that stock undervalued if all the peers in the industry are trading at 5x P/E? Avoid the herd mentality that a P/E ratio can be applied across all companies in all industries.
5) A Limiting Ratio
One of the most limiting factors with a P/E ratio is the lack of visibility into future performance. Generally speaking, a P/E ratio is completely backward-looking. Large companies typically give guidance on next year’s performance, which helps understand a stock’s value on a one-year basis.
However, there’s a lot of companies out there that don’t even provide guidance on next year’s performance. If you are using the P/E ratio on a trailing basis, you can miss the bigger picture on the valuation on a go-forward basis. The stock market will always be forward-looking. If the stock is cyclical, you can be in big trouble if you are buying peak earnings (i.e., low P/E ratio).
If you want to discover a valuation metric better than the pe ratio, with which you can create a portfolio that beats the market easily, I recommend you read this article:
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