Price to earnings ratios can be moderately useful when looking at the stock market as a whole. However a P/E ratio can be quite misleading when looking at an individual stock.
That is because the "E" in a P/E ratio is based on either past earnings, or projected earnings, which may not be reflective of what is really going to happen. Here are the two reasons price to earnings ratios can be misleading.
Calculating Price to Earnings(P/E) Ratios: WIDGET
Suppose you are looking at buying WIDGET stock, symbol WDGT. Here are the facts:
- The stock is selling at $20 per share.
- Last year, WIDGET had earnings of $1 per share.
- Analysts estimate the company will earn $2 per share this year.
- P/E ratio based on past earnings is 20. Calculation: $20/$1 = 20.
- P/E ratio based on projected earnings is 10. Calculation: $20/$2 = 10.
This means you are willing to pay $10 for every dollar of projected earnings. This is also referred to as paying “10x” earnings, or the stock is said to have "an earnings multiple of 10".
Comparing P/E Ratios: GZMO
You compare WDGT stock to GIZMO, symbol GZMO. Here are the facts:
In comparison to WDGT, GZMO appears to be more expensive, as you have to pay more today for the same amount of expected future earnings.
You buy WDGT.
The fallacy of P/E ratios when comparing individual stocks: WIDGET vs. GIZMO
A few months after you buy WDGT, someone files a lawsuit naming one of WDGT’s well known products as a problem. People stop buying this product, and WDGT’s earnings go down. The stock price goes down too.
GZMO, on the other hand, releases a new product that starts selling like hotcakes. GZMO’s earnings go up, and so does the stock price.
Now WDGT is at $15 per share with $1.50 of earnings per share. It now has a P/E of 10.
GZMO is selling at $15 per share with $.75 of earnings per share. It now has a P/E of 20.
You decide that GZMO is growing faster, so you sell WDGT, realize your $5 per share loss, and buy GZMO.
A year later, WDGT’s lawsuit gets dismissed. GZMO’s product, although popular, was a quick fad, and they had no more new products in the production line.
WDGT’s stock steadily climbs to $25 per share. Their earnings rise to $2.25.
GZMO’s stock drops to $9 per share. Their earnings go back to $.50.
Because of constant changes, as described in the above examples, price to earnings ratios should not be used to determine if an individual stock is appropriately valued.
