Flaws In The P/E Ratio

Feb. 15, 2014 1:04 PM ET
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Contributor Since 2011

Michael C. Thomsett is a widely published options author. His "Getting Started in Options" (Wiley, 9th edition) has sold over 300,000 copies. He also is author of "Options Trading for the Conservative Investor" and "The Options Trading Body of Knowledge" (both FT Press); and "Options for Risk-Free Portfolios" and "Options for Swing Trading" (both Palgrave Macmillan). Thomsett also writes for www.TheStreet.com and the StockCharts.com Top Advisor Corner 

The P/E ratio is one of the best-known and widely used indicators. It is also one of the least understood.

P/E compares current share price to earnings per share (EPS). So a technical (price) is calculated based on a fundamental (EPS). A few important flaws to remember about P/E:

1. It compares information from different time periods. The price is today's price per share, but the EPS is the latest annual earnings, divided by outstanding shares. So today's price is compared to last year's earnings. The farther away from the end of the fiscal year, the less reliable the P/E.

2. Using the forward P/E instead of historical P/E is only a guess. Some analysts overcome the timing issue by using forward P/E. Instead of using last year's EPS, this formula used estimated EPS over the coming year.

3. The significance of the multiplier is not well understood. The number you get by dividing price by EPS represents the years' of earnings in current price. For example, if current price per share is $52.50 and the latest EPS is $3.25, P/E is:

$52.50 ÷ $3.25 = 16.2

This means the current price of $52.50 is equal to 16.2 years of earnings. But for most investors, it is difficult to translate P/E into a decision about whether the stock price is reasonable, or too high.

Most analysts agree that a moderate P/E - for example, between 10 and 25 - means the stock price is at a reasonable level. A higher P/E represents much less of a bargain.

Because both price and earnings can vary considerably, P/E should be studied over several years. In addition, pay attention to the annual range of P/E from high to low. This shows the long-term trend in the P/E multiple.

This is only one of several indicators valuable in picking stocks. But it is important to use the trend rather than a single entry, because the trend, as always, reveals a better picture of the stock's health.

To gain more perspective on insights to investing observations and specific analysis, I hope you will join me at ThomsettStocks.com where I publish many additional articles. I also maintain a virtual portfolio of stock at ThomsettStocks.com. For new trades, I usually include a stock chart marked up with reversal and confirmation, and provide detailed explanations of my rationale. Link to the site to learn more.

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