The price-to-earnings ratio, or P/E ratio, is one of the first things that investors see before making investment decisions, But, like any other ratio, it has its limitations. Price to Earning Ratio is a way to measure how much investors are willing to pay for a stock about how much money the company is earning. The P/E ratio is calculated by dividing the current market price of a stock by the company’s earnings per share. A higher P/E ratio means that investors are paying more for the stock of the company’s earnings, and vice versa.
For example, if a stock is currently trading at ₹2,000 and the company’s earnings per share is ₹50, the P/E ratio would be 40 (2,000 / 50). This means that investors are willing to pay ₹40 for every ₹1 of the company’s earnings.
What is important to note here is that there are certain cases where the PE Ratio fails as an accurate metric for measuring stock performance and might mislead an investor. Let’s have a look at some of these instances-
- One-Time Gains/Losses: The P/E ratio is calculated by dividing the current market price of a stock by its earnings per share (EPS). However, the EPS is calculated by taking the net income of a company and dividing it by the number of outstanding shares. There are some ‘black swan’ (one-time) events which might lead to the company having extraordinary losses or gains. These one-time gains or losses, such as the sale of a subsidiary or a large legal settlement. These “extraordinary items” can greatly skew the EPS and, therefore, the P/E ratio. For example, COVID-19 was a black swan event which proved to be a disaster for the hospitality sector, hotels and restaurants all around the world were shut down and thereby took a substantial hit on earnings, which would subsequently increase the PE Ratios of these listed companies owing to this one-time loss and present an incomplete picture of the scenario. Therefore, the ratio does not take into account such instances of windfall gains or losses.
- Commodity Businesses: The P/E ratio is based on the assumption that a company’s future earnings will be similar to its past earnings. But companies that operate in commodity-based industries, such as oil and gas or metals and mining, may have difficulty predicting their future earnings because they are heavily influenced by the fluctuations in commodity prices. For example, oil marketing companies make higher profits when the crude oil prices are low as compared to when the oil prices are high. Since crude oil prices are something which cannot be predicted, Future profits of the OMCs are also uncertain making P/E Ratio an inefficient way to value commodity businesses.
- Accounting for Growth: One big thing it fails to take into account is the growth potential of a company. Sure, it tells you how much the stock is being traded for in relation to its current earnings, but what about its future earnings? A company could have patents for some revolutionary technology or unexplored natural resources that could lead to considerable gains in the future, but its P/E ratio would still be based on its current earnings alone. So, while the P/E ratio can give you an idea of how the stock is valued with respect to its past earnings, it doesn’t give the whole picture when it comes to a company’s potential for growth. It’s important to consider this when evaluating a stock because even if the P/E ratio is high, it might still be worth investing in if the company has a bright future.
- Ignores Balance Sheet: Using the Price to Earnings ratio to value a company can be misleading, as it fails to consider a company’s financial health. While the P/E ratio is a popular and convenient tool for evaluating a stock’s value, it doesn’t take into account a company’s liabilities or assets. This can lead to a false sense of a company’s worth. Imagine you’re looking at two companies, one with a high P/E ratio, and the other with a low P/E ratio. On the surface, a company with a high P/E ratio might seem overvalued, but if it has a solid balance sheet and a lot of assets, it could actually be a great investment opportunity. On the other hand, a company with a low P/E ratio may seem like a steal, but if it has a lot of debt and few assets, it could be a risky bet. Ignoring the balance sheet when evaluating a company’s value can cause you to miss out on great investment opportunities or fall into traps.
- Loss-Making Companies: One drawback of using the Price to Earnings (P/E) ratio as a metric for valuing a business is that it is not well suited for companies currently operating at a loss. The P/E ratio compares a company’s stock price to its earnings per share (EPS), and a company that has negative earnings will have an undefined or infinite P/E ratio, making it difficult to use as a benchmark for comparison with other companies or for determining whether the stock is over or undervalued. Additionally, the P/E ratio doesn’t consider the future potential of a loss-making company, which may be turning a corner and on the verge of profitability. This can make it hard for investors to identify undervalued opportunities in such companies and miss out on potential gains. In sum, the P/E ratio is not suitable for evaluating loss-making businesses. For Eg. Wealth creators such as Amazon were loss-making for the first nine years of their existence.
- Industry Comparisons: Different industries have different characteristics, such as different growth rates, margins, and capital requirements. For example, in the case of metal companies, they tend to have low P/E ratios as they are often characterized by low growth, high capital requirements, and fluctuations in commodity prices. On the other hand, Fast-moving consumer goods (FMCG) companies have high P/E ratios because they have a more steady and predictable revenue stream, and they tend to have a higher growth rate. A P/E ratio that looks attractive for metal companies may not be the same for FMCG companies.
- Quality of Earning: Price to Earning Ratio doesn’t take into account the quality of a company’s earnings. This can be especially problematic when evaluating a company’s longevity of earnings and diversification of revenue. A company with a high P/E ratio may have high earnings, but if the majority of those earnings come from a single product or market, it may not be sustainable in the long term. On the other hand, a company with a lower P/E ratio may have lower earnings, but if those earnings are diversified and sustainable, it could be a better investment opportunity. In this scenario, the P/E ratio can give a misleading impression of a company’s true value. It’s important to consider the quality of a company’s earnings, including its longevity and diversification, when evaluating its P/E ratio to make informed investment decisions.
- Ignores Cash Flow: Cash-flow is an essential factor in evaluating a company’s financial health, but unfortunately, the Price to Earning ratio ignores it. This means that a company with high profits may not necessarily have a healthy cash flow. For example, a company with high profits may have high average debtor days, indicating that it takes longer for the company to collect payments from its customers. This means that even though the company is profitable, it may struggle to pay its bills and debts on time, which could lead to financial difficulties. Therefore, it is important to consider both the price-to-earnings ratio and the company’s cash flow when evaluating its financial performance.
PE ratio is easy to calculate and thereby popular but is certainly not short on misleading elements. It’s important to note that the P/E ratio should not be used as the sole measure of a company’s valuation. Investors should evaluate other valuation metrics such as Price to Book, Dividend Yield, and Price to Sales, and also consider the nature of the company, including its management, growth prospects, and financials. To make informed investment decisions, investors should use a combination of metrics and conduct thorough research on the company they are considering investing in.