For instance if a company’s stock price is $80 and its reported earnings per share for last year is $8, then it has a P/E of $80/$8 = 10. One way to look at it is that every year the company earns 1/10 of its price so if you buy its stock it will be paid back in 10 years from now thanks to the company earnings.
People tell you that if you compare the P/E of the firm with its peers, it gives a good indicator of whether the company is over or undervalued. For instance if a company is a US insurer and has a P/E of 7 when all other US insurers have a P/E of 10 it should tell you that your company is undervalued and that you should buy. Or people also tell you that for most industries a cash-cow type of company should typically have a P/E of 7-11, a growth firm a P/E of 15-40 and a start-up a P/E of higher than this and that if prices are not in this ranges you should buy/sell accordingly. Well think twice before you draw these conclusions! We are going to show you that the P/E ratio is something that you should definitely not trust. Not at all.
First the P/E does not take into account the inflation or depreciation of inventory: raw materials, components, equipment to be replaced, and even the goods sold by the company usually tend to have an increasing cost because of inflation, and this inflation can be very high at times. The earnings are usually based on old figures with regards to costs. So the Earnings in the P/E would need to be inflation-adjusted. But they are not. For instance the price of corn doubled in the US between May 2010 and May 2011. Such a steep price increase is extremely relevant if you are valuing a firm buying a lot of corn, such as a cattle producer but this will not appear in the P/E.
Second the P/E looks at last year’s performance to evaluate the future: the E in the P/E ratio is the earnings from last year. And you probably have noticed that we live in a world that is changing very quickly: the average phone sold today has more computing power than most laptops had 5 years ago, China’s GDP was multiplied by 4 in the last 10 years, facebook is not even 10 year old and already claims 1 billion users per month…. The list goes on. In such environment not many firms can claim that their earnings will for sure remain stable over time, and last year’s earning are nice to have but not really relevant at telling you what the company is going to perform in the future. Having a view at the firm’s future products, relative position in its industry, and long-term strategy is more interesting. And therefore it is wrong to use P/E for company valuation in our quickly changing world.
Third, and probably the most import, the P/E is based on the declared earnings from the company’s annual report, which is a highly unreliable figure: if you have studied a little financial accounting you understand that the accounting rules such as the GAAP (General Accepted Accounting Principles) actually do change from country to country so the definition of Earnings for a multinational depends on where they decide to consolidate their accounts. Moreover the US regulations alone are still vague enough so that the CFOs of companies have plenty of freedom to twist the numbers and report the earnings they feel like, at least as long as the company is not bankrupt. For instance if the company had a very good year the management can decide to artificially reduce the company earnings in the annual report. The CFO lowers the earnings so he can also lower the company tax bill. For instance, a very commonly used trick is to tell in the annual report that some of the customers will probably not pay what they owe the company, so the company already takes this into account as a loss. But of course customers do pay during the following year! And the company can then declare the earnings with one year delay. I am not talking about illegal practices or fraud. These are common practices done all the time by most companies out there and which purely and simply discredit the P/E as a valuable valuation metric.
So all in all the P/E is really not useful at telling you which company to invest in. And this can actually be reflected by the disparity of the P/Es that you can see in the market even within a similar industry. For instance as of today the French insurer Axa has a P/E of 7.72 while its German competitor Allianz has a P/E of 9,7 does that mean that Axa is a firm undervalued compared to Allianz ? Well, not at all.