Never Use P/E Ratios in Isolation

Different Types of P/E Ratios

It's important to understand that all P/E ratios are not created equally. Some are calculated using earnings from the past four quarters (known as a trailing P/E). Meanwhile, others use earnings from the last two quarters, plus projected earnings for the next two quarters (known as a current P/E). Finally, some are calculated based entirely on future earnings estimates (known as a forward P/E).

Caution must be used when examining forward P/E ratios, as future growth estimates may ultimately prove to be inaccurate. Also, the underlying earnings used in the P/E calculation can vary from source to source. Some analysts, for example, choose to work with adjusted earnings figures, which exclude one-time gains or losses. Meanwhile, others prefer to use net income figures calculated based on traditional GAAP rules.

Never Use P/E Ratios in Isolation
Although a P/E ratio can provide a good approximation of how "expensive" a particular stock is relative to its underlying earnings stream, it is by no means a perfect gauge of a company's value. P/E ratios have a number of drawbacks, including:

-- Earnings Manipulation -- Companies often use a variety of accounting techniques to alter their reported net income. As a result, the reported earnings figures we read about are often not entirely representative of a company's true financial situation. Since net income is a critical component of a firm's P/E ratio, manipulated earnings can lead to misleading P/E data.

-- Industry Differences -- Different industries typically have different historical growth rates, risk levels, etc... and hence different average P/E ratios. Thus, stocks that may appear cheap in one industry may look expensive when stacked up against another. For this reason, it is typically more appropriate to compare a firm's P/E ratio to those of other companies within the same sector.

-- Other Factors -- It's important to remember that P/E ratios only take two items into account -- a firm's current stock price and its net income. As a result, P/E ratios completely ignore a variety of other important factors. One of the most notable of these factors is a firm's projected future growth rate. Two stocks could be identical in every respect (including on a P/E basis), but if one company is growing at twice the rate of the other firm, then the high-growth firm will likely make a better investment over the long haul. With this in mind, many investors prefer to examine PEG ratios as opposed to traditional P/E ratios.

-- Volatility and Risk -- P/E ratios also ignore such critical items as risk and volatility. Two firm's may sport identical P/E ratios, but if one firm's revenue and earnings base is extremely reliable, yet the other firm's earnings are highly uncertain, then the more reliable firm could make a better investment over the long haul.

With the above limitations in mind, when attempting to assess the value of a particular security, most experienced investors choose to analyze P/E ratios in conjunction with a variety of other ratios, including Price/Sales (P/S), Price/Cash Flow (P/CF), etc...



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