So far we’ve learned that, in the right circumstances, the P/E ratio can help us determine whether a company is over- or under-valued. But P/E analysis is only valid in certain circumstances and it has its pitfalls. Some factors that can undermine the usefulness of the P/E ratio include: Accounting Earnings is an accounting figure that includes non-cash items. Furthermore, the guidelines for determining earnings are governed by accounting rules (GAAP) that change over time and are different in each country. To complicate matters, EPS can be twisted, prodded and squeezed into various numbers depending on how you do the books. The result is that we often don’t know whether we are comparing the same figures, or apples to oranges. Inflation In times of high inflation, inventory and depreciation costs tend to be understated because the replacement costs of goods and equipment rises with the general level of prices. Thus, P/E ratios tend to be lower during times of high inflation because the market sees earnings as artificially distorted upwards. As with all ratios, it’s more valuable to look at the P/E over time in order to determine the trend. Inflation makes this difficult, as past information is less useful today.

Many Interpretations A low P/E ratio does not necessarily mean that a company is undervalued. Rather, it could mean that the market believes the company is headed for trouble in the near future. Stocks that go down usually do so for a reason. It may be that a company has warned that earnings will come in lower than expected. This wouldn’t be reflected in a trailing P/E ratio until earnings are actually released, during which time the company might look undervalued.

Don’t Buy/Short Just Because of the P/E What goes up … well, sometimes it stays up for an awfully long time. A common mistake among beginning investors is the short selling of stocks because they have a high P/E ratio. If you aren’t familiar with short selling, it’s an investing technique by which an investor can make money when a shorted security falls in value. First of all, we believe that novice investors shouldn’t be shorting. Secondly, you can get into a lot of trouble by valuing stocks using only simple indicators such as the P/E ratio. Although a high P/E ratio could mean that a stock is overvalued, there is no guarantee that it will come back down anytime soon. On the flipside, even if a stock is undervalued, it could take years for the market to value it in the proper way. Security analysis requires a great deal more than understanding a few ratios. While the P/E is one part of the puzzle, it’s definitely not a crystal ball.

Conclusion

What have we learned about the P/E ratio? Although the P/E often doesn’t tell us much, it can be useful to compare the P/E of one company to another in the same industry, to the market in general, or to the company’s own historical P/E ratios.

Some points to remember:

• The P/E ratio is the current stock price of a company divided by its earnings per share (EPS).
• Variations exist using trailing EPS, forward EPS, or an average of the two.
• Historically, the average P/E ratio in the market has been around 15-25.
• Theoretically, a stock’s P/E tells us how much investors are willing to pay per dollar of earnings.
• A better interpretation of the P/E ratio is to see it as a reflection of the market’s optimism concerning a firm’s growth prospects.
• The P/E ratio is a much better indicator of a stock’s value than the market price alone.
• In general, it’s difficult to say whether a particular P/E is high or low without taking into account growth rates and the industry.
• Changes in accounting rules as well as differing EPS calculations can make analysis difficult.
• P/E ratios are generally lower during times of high inflation.
• There are many explanations as to why a company has a low P/E.
• Don’t base any buy or sell decision on the multiple alone.