Why The PE Ratio Is Widely Misunderstood and People Get It Wrong | Exploring Markets

Why The PE Ratio Is Widely Misunderstood and People Get It Wrong

The price-to-earnings ratio, or P/E ratio, is one of the most widely cited and calculated metrics in all of finance. That's why you should understand it and have a firm grasp of it.

First and foremost, a high P/E ratio does not mean a stock is overvalued. A low P/E ratio does not mean a stock is undervalued. This is a massive misconception that surrounds the price-to-earnings ratio.

The stock market is a forward and future looking mechanism. This means that the big players, like mutual funds, banks, and hedge funds (the ones who move the stock market on a daily basis) make most of their decisions based on future estimates. A popular example of this is what experts call "discounting future cash flows". This is the conversion of cash flows expected in the future to a present value today.

The price-to-earnings ratio, however, is a lagging indicator. It is calculated by dividing the current price of a stock by its most recent earnings report. Read that sentence again and you can see where the conflict begins. The big players in the stock market discount future earnings while the price-to-earnings ratio looks at past earnings.

The exact formula for the P/E ratio is Price Per Share divided by Earnings Per Share.

As a quick example, imagine a company has a P/E ratio of 5 and has been incredibly profitable in the past. This, upon hearing, sounds like a great investment. It's P/E ratio is only 5! That's one of the lowest P/E ratios out there. But consider for a second that while they have been incredibly profitable, in their latest earnings report they revealed that tumultuous earnings would be coming in the next year because of a manufacturing problem. So while they were still profitable in the past, they broke the news that they would lose vast sums of money in the future. When big players hear this, they model their estimates and discount future cash flows to reflect this terrible news. In this instance, the P/E ratio will only get lower. That's counter-intuitive though because investors are trained to look for low P/E ratios. But in this instance it's actually a BAD thing. The P/E ratio is low because it's not going to make much money in the future.

The example above can work in both ways. A high P/E ratio sounds daunting and frightening. But also could just simply mean that a company is predicting massive growth in cash flows and earnings. This drives its price up and makes its P/E ratio high.

The lesson here is that the P/E ratio is an incomplete metric. In no way does it paint the full picture of a stock. New investors and traders should understand this. Please leave questions or comments below.