The P/E ratio helps investors screen for potentially undervalued companies and provides a clue as to whether a company is overvalued or undervalued. The P/E ratio is calculated by dividing the price per share by the earnings per share for the previous 12 months. Earnings are also referred to as earnings after tax, net earnings, profit, net profit, or the bottom line.

The P/E ratio is a great way to identify companies that look cheap compared to their industry and serves as an indicator of where a company is in its lifecycle. It’s an excellent screening tool, but you need more information to get the full picture.

For example, if you compare two companies, one with a P/E of 5 and another with a P/E of 10, the lower P/E might seem like the better deal. However, this can be misleading for several reasons. A low P/E often suggests a company’s high-growth phase is in the past, while a high P/E indicates expectations of future growth. This means both could be fairly valued within their context. All stocks are constantly swinging between over- and under-valued.

A P/E of 5 means that the company’s stock price is five times its earnings. Investors often assume that lower P/E ratios indicate a faster return on investment, but this does not account for factors like growth, industry trends, or market sentiment. The P/E ratio does not take growth into consideration, meaning two companies with vastly different P/E’s can both be fairly valued.

Limitations of the P/E Ratio

Let’s break it down:

• P = Price today. That’s the straightforward part.

• E = Earnings. This usually refers to the earnings from the last four quarterly reports (the last 12 reported months).

However, earnings are an accounting term and not the same as cash at the end of the year. For instance, a company with many depreciating assets might report low net profit/earnings but still generate significant cash.

Additionally, the P/E ratio doesn’t reflect changes in earnings over time. It uses past data, so if a company’s earnings are improving each quarter, the ratio won’t show this. When calculating P/E yourself, you might consider using 4x the last quarter’s earnings or even future estimates for a more accurate picture. If you want a more comprehensive valuation metric, consider the PEG ratio (Price/Earnings-to-Growth), which incorporates expected earnings growth. However, using growth projections introduces more uncertainty.

Creative bookkeeping and tax planning can also distort earnings. For instance:

• A company might take a loss from a bad investment in a good year to lower taxes, reducing reported earnings.

• Conversely, selling a profitable investment in a bad year can inflate earnings.

To get the full story, examine the income statement and cash flow statement to understand what’s happened over the last year or more.

Lastly, analysts working for big banks are not necessarily on your side. They aim to increase trades (and profits for their employers) by promoting companies with “bright futures.” They often base projections on future earnings rather than historical data, making a company seem cheaper. Be cautious—future earnings projections may not materialize.

How to Use the P/E Ratio Effectively

The P/E ratio should be a clue, not a confirmation to buy. Look at actual earnings over a 3-, 5-, or 10-year span. If earnings are consistently growing, the business might be a solid investment. Stagnant or declining earnings can indicate a company losing market share, which is a red flag for long-term investors.

Pros and Cons of the P/E Ratio

Pros:

1. Simplicity: Easy to calculate and compare across companies or industries.

2. Growth Insights: A high P/E can indicate high growth expectations. Tracking a company’s P/E over time can reveal whether it’s growing or mature.

Cons:

1. Earnings Dependence: Negative or volatile earnings can render the P/E ratio meaningless or misleading.

2. Industry Differences: P/E comparisons across industries (e.g., chipmakers vs. power plants) don’t provide meaningful insights.

3. Trailing Data: The ratio is based on past performance, not future potential.

An Example to Tie It All Together

Here are the P/E ratios for some car manufacturers (as of 2025-01-24):

• Tesla: 113

• Ford Motor Company: 11.44

• Volvo Car AB: 4.4

• Rivian Automotive: -2.2

All are in the same industry, but their P/E ratios vary dramatically. Tesla’s high P/E reflects optimism about its future, while Rivian’s negative P/E indicates it’s bleeding money.

As you can see, P/E ratios vary widely even among companies in the same industry. Investors should consider other factors such as earnings growth, cash flow, and competitive advantages before making decisions.

This highlights why P/E alone isn’t enough. Public perception of a company’s future greatly influences its P/E. A high P/E suggests optimism and growth potential. A low P/E might indicate that growth is in the past—making it interesting for dividend investors, and even more interesting if they are buying back shares.

If you’re looking for the next Amazon, Netflix, or Tesla, you might focus on growing companies with high valuations and low, but growing, earnings.

I hope this helps you navigate the world of investing and find what you’re looking for!