5 Flaws in a Simple Price to Earnings (PE) Ratio

Aaron Smith

Posted on Thu 7th May, 2009 12:24:43 PM

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The price earnings ratio, or the P/E ratio, is the most well-known of all the valuation ratios because of its age and how widely used it is. Value investors are known to be particularly fond of this method of valuing a stock’s worth. The P/E ratio is a very helpful tool to help value the price of a stock, but there are certainly some major flaws in using a price to earnings ratio as a major investment decision maker.

5 Major Flaws in the Price to Earnings Ratio

1. Too simplistic- One of the biggest positives of the P/E ratio is also its biggest flaw, at least in my book. The price to earnings ratio is just too simplistic to capture so many important variables in a stock’s worth. Does simply taking the current price of the stock and dividing it by the company’s most recent earnings number seem too easy? That’s because it really is.
2. Doesn’t account for growth- The price to earnings ratio doesn’t account for any type of growth or the lack of growth. The fact that growth isn’t factored in means that older more mature stocks are typically going to appear cheaper even if they aren’t growing if you use the P/E ratio. For many investors growth is a variable they do not want to exclude.
3. Backward looking- The P/E ratio is actually a backward looking indicator if you use the company’s most recent full year earnings number. A backward looking number can be of very little help to the investor during a period where economic conditions have changed significantly in a short period of time.
4. Quality of earnings not considered- The last several months have been the perfect example of how a company can really inflate their earnings to look better than they really are. Many banks were able to do this for months, and because of that investors that solely used the P/E ratio would have thought they were great buys. In retrospect if the investor had been looking at other parts of the balance sheet they may have seen inflated earnings as a real issue.
5. The P doesn’t consider debt- Companies with major debt issues are obviously higher risk investments, but the P in the P/E ratio only considers the equity price and does nothing with the debt that the business has to continue with operations. As we have found out over time, excess debt can be a real problem, and the market price of a stock isn’t always a good gauge of fair value.

The Price to Earnings ratio still has a place in valuing stocks, but investors using it need to understand the problems that come with it. Use the P/E ratio in combination with other valuation methods, but never as the sole reason for investing in a company.

Aaron K. Smith is a freelance writer with experience working in the mutual fund industry and writing about investing and the stock market. View all posts by Aaron.

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