Accounting Income Is Generally Equal To Operating Cash Flow 5 Common Misuse of P/E Ratio

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5 Common Misuse of P/E Ratio

The Price Earnings (P/E) ratio is the most commonly used ratio in investing. A Google search for the term ‘P/E ratio’ will yield 2.3 million results. In very simple terms, the P/E ratio is the ratio of the share price divided by its earnings per share (EPS). If a company A is trading at $10 per share and it earns $2.00 per share, then A’s P/E ratio is 5. This means it takes 5 years for the company to generate revenue for your initial investment. If you reverse the P/E ratio, we get the E/P ratio, which is the return on our investment. In this case, a P/E of 5 equals a yield of 20%.

The P/E ratio is convenient and very easy to use. But that is why many investors misuse it. Here are some common misuses of the P/E ratio:

Using the trailing P/E. Trailing P/E is a company’s price-earnings ratio over the last 12 months. For cyclical companies approaching earnings peaks, the P/E ratio is misleading. The trailing P/E ratio may look low but its forward P/E may not. Forward P/E is calculated using the company’s estimated earnings per share. Forward P/E is more important than trailing P/E. After all, it’s the future that matters.

Ignore earnings growth. A low P/E ratio does not necessarily mean that the stock is undervalued. Investors must consider the company’s growth rate. Company A with a P/E ratio of 15 and 0% earnings growth may not look as attractive as Company B with a P/E ratio of 20 and 25% earnings growth. This is because if both share prices remain the same, after 3 years, company B’s P/E ratio will decrease to 10.3 while A’s P/E ratio will still be 15. The moral of the story here is don’t use P. /E ratio for determining property value.

Ignoring a one-time event. The P/E ratio always includes one-time events such as restructuring costs or downward adjustments in goodwill. When this happens, the ‘E’ in the P/E ratio will appear lower. Consequently, this phenomenon increases the P/E ratio. Investors would do well to ignore this one-time event and look beyond the high P/E ratio.

Ignoring the balance sheet. That’s right. Investors often overlook cash and long-term debt embedded in the balance sheet when calculating the P/E ratio. The truth is, companies with more net cash on their balance sheets usually have higher P/E valuations.

Ignore the interest rate. Using only P/E ratio for our investment decision will lead to disastrous results. As mentioned earlier, when we invert the P/E ratio, we get the E/P ratio. The E/P ratio is essentially the return on our investment. A stock with a P/E of 10 is yielding 10%. A stock with a P/E of 20 is yielding 5% and up. If interest rates rise to 6%, stocks trading at a P/E of 20 will be overvalued, all else being equal.

Unlike other financial ratios, the P/E ratio cannot be used solely to value a company. Interest rates fluctuate, earnings per share go up and down, and share prices also go up. All these things should be taken into consideration when choosing your potential investment.

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