- P/E ratio is not the be all and end all of valuation metrics.
- Is it skewed in favor of market reactions rather than fundamentals?
- Key factors to be considered before applying PE ratio.
- Other relevant ratios : Price Earnings Growth ratio, Free Cash flows.
What does the P/E Ratio mean? Is it a statement a layman makes to appear as a well informed investor? I have been asked this question by quite a few supposedly well-informed investors in discussions involving stock markets and stock valuations. So, is the PE Ratio a good indicator of a stocks valuation? Is it the be all and end all of valuation metrics? These are questions that may some times draw a blank response from even the most active of stock market investors.
Price earnings ratio is quite a simple metric to compute, it is the current market price of the stock divided by its Earnings per share. Earnings per share is computed by dividing Profits available to equity share holders by the total number of outstanding shares of the company. The basic formula throws up quite a few questions:
- What if the earnings are negative?
- What if the earnings are minuscule but the market price is high?
- How does one understand market price movements? Fundamentals or sentiments?
- Are earnings per share actual reflection of the company's operating earnings?
- Is it "THE" metric which one should use to evaluate a stock? Does it take the future growth potential into consideration?
One can make an investment choice after understanding the above questions on PE ratios.
Company with negative earnings
Right away PE ratios do not apply to companies with negative earnings, as it is a mathematical impossibility for a company with negative earnings to have a PE ratio computed. This is actually a lacuna in the metric, which disregards companies with negative earnings. Any company with cyclical earnings will go through a negative earnings phase which cannot be handled by the PE ratio.
Minuscule earnings compared to the market price
This is again an incorrect indicator as the market may factor in investor sentiments and the market price may have a sudden hockey stick jump. The earnings may not be up to the mark at the moment but the stock would still have a high PE ratio due to investor sentiments driving up the price.
Understanding stock market price movements
There is no single metric which can fully justify stock price movements. There are companies which are purely sentiment driven and there are others which are driven by fundamentals. A sentiment driven company may have poor fundamentals but still have a high PE ratio, whereas a fundamentally strong company may have poor market sentiment and hence lower PE ratio.
Are earnings per share actual reflection of operating earnings?
Earnings per share involve computing profits available to equity shareholders by the number of shares held by them. These profits consist of what is other income or income that is not from the core operations of the company. There may be cases where the core operating revenue could be minimal in comparison with other income, which could arise from sale of assets or interests on deposits held with banks and various other non-operating events. Earnings, which include such other income, are not true indicators of performance and hence the derived PE ratio may also not be a good valuation indicator.
Is Price Earnings ratio "THE" metric for stock evaluation
PE ratio cannot be considered to be “THE” metric, which one should use to evaluate a stock. There are other relatively useful metrics (we discuss only two here!)such as the Price Earnings Growth ratio (PEG Ratio), which also considers the critical factor of growth in valuing a specific stock. Another key indicator could be the computation of free cash flows generated by the company. This indicator cuts the assumptions and accruals involved in accounting and focuses purely on the cash generating capability of a company.
Price to Earnings ratio has long been considered as one of the key ratios in valuing a stock. This is an oft published ratio as well, along with daily stock prices in financial dailies. Having said that it is not the be all and end all of all the valuation ratios available. Though it can be considered as an important valuation metric, there are other ratios, which depict a more realistic picture. When it comes to tech stocks, one needs to be specially cautious. Technology stocks being high growth in nature have always enjoyed high PE ratio (Ex: Amazon).
The PE ratio used in tandem with other metrics like PEG ratio, EV/EBITDA multiple help to overcome the limitations of the PE ratio and to present a complete overall picture. An investor must take into account these other metrics before making an investment decision.