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P/E Ratio - How Valuable Is It?
A stock's P/E ratio can be a nice guideline as to the financial condition of a company, but how valuable is that information? To determine that, we need to evaluate exactly what a P/E ratio is. In simple terms it is the stock's current price divided by the previous 12 months earnings per share. However, if you examine the components of the ratio more closely, fundamental flaws will appear.
For starters, the ratio uses historical data (previous earnings) in conjunction with dynamic current data (the price of the stock). Historical value is just that: History. While a company's future earnings may be similar to previous earnings it can be difficult to determine for several reasons. For example, the company may have gone through reorganization so it had poor earnings last year, or maybe the company released a new product last year so it had higher profits than it can expect this year. Worse yet, maybe the company had to borrow more money so it has higher interest payments reducing profits, or maybe the company issued more stock making it less profitable per share. There are literally hundreds of factors like these that can devalue the importance of the P/E ratio.
To offer more current information many websites have a forward P/E ratio in addition to the standard P/E ratio. The forward P/E ratio is the average earnings estimates provided by analysts divided into the current price. While there may be some value to this number, unforeseen events happen all the time changing the projected earnings of the company. Furthermore, only the large companies have enough analysts following their stock to offer useful projections. Many smaller companies only have 1 or 2, if any, analysts following their stock.
So am I telling you that the P/E ratio is useless? Absolutely not, it is a very good starting point when researching a stock. However, it is only a number to start with. Dig deeper into the number to find out what is really going on with the company. Just because a book has a pretty cover it doesn't mean it is worth reading. A stock may have an attractive P/E ratio, but that number may be hiding something else. Find out for yourself.
