When it comes to
valuing a stock, its P/E is the most common
criteria used; however, is the P/E Ratio the best method of
deciding a stock's value? When used to
determine a stock's
value, P/E ratio alone can be very misleading.
Consider the following:
You are a young entrepreneur who decided to open
a retail store. After several years of hard
work, you now own a chain of 5 stores, and are
making a very nice living of $500K a year.
Now you are getting tired of running
the business and decide to sell. You call a
business evaluator who estimates the value of
your retail chain stores using the standard 2-3
times net earnings, or $1-1.5 Million.
Now imagine the
same above scenario, but this time you are
still excited about your retail concept and
want to continue to expand. You decide to go public to raise money for future store
development. You show a strong growth rate,
Wall Street loves you and estimates the value of
your company at 50 times earnings, or a cool $25
Now, does the
above make sense? Not to me, and not to anyone
who ever ran a privately owned business. Regardless, the above
is the reality with respect to how stock values are
determined on Wall Street. So, the next time
you try to make sense out of P/E ratios, just
tell yourself, "It is not real; it is just a
Is the PE Ratio the best method of deciding if
a stock is a value stock? Don't bet on it; when
it comes to value stocks, the P/E ratio alone can be
The PE Ratio
(Price / Earnings ratio) is the price of a stock
divided by past or future earnings (PE ratio =
Price / Earnings). Example, if the price of IBM
is $100 and the company earned $10 per share
over the past 12 months, then the trailing
twelve month PE ratio would be $100 / $10 or 10.
When most investors think about stock valuation,
there is one figure that springs to mind--and too
often, it is the only one: the price-earnings
ratio. While it may be tempting to substitute that
for real research, watch out: the ratio can be
misleading. Even low-P/E stocks can leave you with
a queasy stomach--when you later discover the
reason they were so cheap. Likewise, a high P/E
doesn't necessarily mean a company's overvalued.
There are plenty of good reasons that investors
might want to pay a premium for out performance.
Putting too much emphasis on PE ratios is
especially misleading when companies miss their
earning estimates. Due to these hopefully
temporary problems, the average company's PE
ratios will be restated, and in many cases
accounting charges will also have to be taken.
The bottom line is that typically these companies
will show an unattractive high PE ratio, and in
many cases will even have a loss. This, however,
is only temporary, and typically reverses itself
after a few short quarters.