PE ratio is also known as the Price-to-Earnings ratio is a famous number that nearly all investor or budding investor or finance enthusiast look at while investing.

In this blog, I shall discuss the PE ratio – what is it, disadvantages of the PE ratio, misinterpretation mistakes common investors do and what an investor should ideally look at while investing instead of PE ratio.

But before that let’s see the background.

Background

PE Ratio is the ratio of – Price per share to Earnings per Share (EPS)

PE ratio = Price per share / Earnings per Share (EPS)

For example –

If a company is trading at Rs 200 and if its earnings per share are Rs 10, the PE multiple is calculated as –

= Rs 200/Rs 10

= 20x

Companies posting losses – negative earnings per share pose a challenge in computing PE ratio.

Theoretical interpretation

Theoretically, the PE ratio tells us how much an investor is willing to pay for every unit of earnings of a company. Thus, it is also referred to as a multiple.

A low PE is generally considered to undervalued while a high PE is deemed to be overvalued.

However, there is a problem. It is undoubtedly a big statement to say if you see anyone claiming that PE ratio is baseless. But read on, and you shall be able to see the logic behind.

PE ratio, by nature, is a retroactive metric and it puts a company’s market capitalization to trailing 12-month profit. But an investor you are more interested in the future of the company and not past.

So, ideally you need to bank on the future cash flow of the company and what matters for you is what the company could do from what it has not done yet.

Following are the factors that undermine the utility of PE ratio.

Accounting –

The PE ratio is dependent on the earnings reported by a company. The earnings reported by a company is not a factor of the revenue and expenses. Expenses also include non-cash items such as depreciation and amortization.
Now, there are different ways of accounting for depreciation and amortization in different countries. Thus, the Earnings Per Share (EPS) which is derived from Profit After Tax (PAT) can be twisted depending on how a company maintains its books. Thus, the PE ratio may not give the real picture of valuation.

An acquisition could help manage PE

Companies often manage their PE ratio by acquiring a company that has significantly lower PE as compared to their own. This results in a lower combined PE ratio. The technique, also known as bootstrapping the PE, could lead to a company’s shares rising without any material earnings growth.

Inflation alters the PE

In a situation when the economy is witnessing high inflation, the inventory and depreciation costs is often understated as the replacement cost rise with high inflation.

Thus, it makes sense to assess the trend of the PE ratio of a company rather than just looking at one year’s number while valuing the company.

Interpretation mistakes investors typically tend to do

A low P/E ratio does not necessarily mean that a company is undervalued. It could also say that the company is heading towards financial trouble. It also could mean that the earnings forecast of the company is low and it has resulted in correction of price thereby PE going significantly down.

Similarly, a company with low earnings could see a high PE ratio, but that doesn’t mean it could be overvalued. It could also be due to the high growth expectation from the company or a recent listing of the company.

Conclusion

To conclude, I can say that the PE multiples are harmful as investors tend to attach meaning to something that is not worthy. Earnings are something that is not real but accounted, and thus an investor should levy more focus on cash flow based approach while valuing a company.

While assessing a potential investment opportunity, an investor should look at the underlying constituents, cash flow generation capability, governance structure, and business competitiveness.

Often you would see economies like China is trading at an attractive multiple to India or half that of Russia or Emerging market as a whole, but this should lead to a conclusion that China is overvalued or undervalued. An investor needs to look at things beyond these ratios. An apple to apple comparison makes more sense than an apple to a basket of fruits.

Disclaimer: the views expressed here are of the author and do not reflect those of Groww.