3 rules when using the P/E ratio

By Morningstar |  18-10-19 | 

The P/E ratio is the ratio obtained by dividing the market price per share by the earnings per share. For example, a Rs 200 share price divided by EPS of Rs 20 represents a P/E ratio of 10. Theoretically, it translated into the assumption that if we were to buy this company today it would take 10 years to earn back our investment.

In this post, the author lists a few issues he has with the P/E ratio. He believes that the most dangerous component of the P/E ratio is that the earnings are the accounting earnings as defined by the accounting standards for a particular country. These earnings are not the cash earnings of the business. The P/E ratio tells us nothing about the quality of a company's earnings. Neither does it throw any light on the company's balance sheet (a low PE company may be incredibly expensive since the company has a very large amount of current debt that it has no way of paying).

In his book Investment Fables, Aswath Damodaran, professor of finance at the Stern School of Business at New York University, notes that investors have always used earnings multiples to judge investments, but the P/E ratio is related to a firm's fundamentals and a low P/E ratio by itself does not indicate an undervalued stock.

The biggest problem with P/E ratios is the variations on earnings per share (EPS) used in computing the multiple. The most common measure of the P/E ratio divides the current price by the earnings per share in the most recent financial year; this yields the current PE.

Other people prefer to compute a more updated measure of EPS by adding up the EPS in each of the last four quarters and dividing the price by this measure of EPS, using it to compute a trailing P/E ratio. Some analysts go even further and use expected EPS in the next financial year in the denominator and compute a forward P/E ratio. 

EPS can also be computed before or after extraordinary items and based upon actual shares outstanding (primary) or all shares that will be outstanding if managers exercise the options that they have been granted (fully diluted). In other words, you should not be surprised to see different P/E ratios reported for the same firm at the same point by different sources. In addition, you should be specific about your definition of a P/E ratio if you decide to construct an investment strategy that revolves around its value.

In his blog post Aswath Damodaran notes that it is a blunt instrument that can get us into trouble, when used casually. A low P/E ratio can be indicative of cheapness, but it can also be the result of high debt ratios and low or no cash holdings. Conversely, a high P/E ratio can point to over priced stocks, but it can be caused by high cash balances and low debt ratios.

He suggests three simple rules for the use of P/E ratios.

  1. When comparing P/E ratios across companies, don't ignore cash holdings and debt.

As the diversity of companies within sectors increases, the old notion of picking the lowest P/E stock as the winner is increasingly questionable, since you may be choosing most highly levered company in the sector.

  1. When comparing P/E ratios across time, don't ignore cash holdings and debt.

I have noted the ebbs and flows in both cash as a percent of firm value and debt as a percent of value across time, sometimes due to shifts in the numerator (cash and debt values changing) and sometimes due to shifts in the denominator (market value of equity changing). Whatever the reasons, these shifts can affect the P/E ratios for the market, making it look expensive when cash balances are high and debt ratios are low.

  1. Any corporate action that changes the cash or debt as a percent of value will change the P/E ratio.

Consider a company that has a large cash balance and is planning on using that cash to buy back stock. Even if nothing else changes, the P/E ratio for the company should decrease after the buyback, as (high PE) cash leaves the company. Thus, the practice of forecasting earnings per share after buybacks and multiplying those earnings per share by a constant PE will overstate value. This effect will be even more pronounced, if the company borrows some or all of the money to fund the buyback, since a higher debt ratio will also push down the PE even further.

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