A low P/E ratio doesn’t necessarily mean that the company is undervalued and is a prospective buy. On the other hand, a high P/E ratio also doesn’t mean that the company is overvalued and we should chuck it aside.
A company with low P/E ratio may not mean that it is attractive (or undervalued) due to the following reasons:
- company has uncertainty over its prospects for earnings
- company is operating in a highly cyclical sector
- company is serving volatile markets
- company is operating in a sector with overcapacity and weak pricing power
- company is operating in a sector with low returns consistently
- company operating in a mature sector, with little prospect for growth
- company is ex growth
- company has poor management with no convincing strategy for growth
- company has poor cash generation
- company has a weak balance sheet
Whereas a company with a high P/E ratio may not mean that it is overvalued due to the following reasons:
- company has an excellent growth record and prospects for growth
- company is operating in a high-growth sector
- there’s high confidence in company’s forecasts
- predictable/stable returns
- strong market share
- high barriers to entry
- strong pricing power
- high margins and excellent returns
- superior management with excellent growth strategies in place
- strong cash generation
- strong balance sheet
P/E ratios also have advantages and disadvantages.
Advantages of P/E ratio:
- easy to compute
- widely used so it’s easy to find a company’s P/E ratio
- takes forecasts into account
- earnings is a measure of what is generated for shareholders
Disadvantages of P/E:
- does not take debt/financial structure of company into account
- gearing up/share buy-backs increase earnings (‘financial engineering’)
- earnings are prone to manipulation by management
- does not take cash generation into account
- presents difficulties in assessing quality of earnings
Thus, P/E ratios must always be compared with companies of the same sector and with the overall market P/E. Various matrices must be looked at (not only P/E ratio) before investing in a company as well.
2 thoughts on “Putting P/E ratio into perspective”
Hi FF now,
You cover almost everything relating to P/E.
But what do think of 5 to 10 years historical PER of a stock?
What can we learn from this comparing to the current P/E of the stock?
The average P/E of stocks on the whole is 15. Anything above 15 indicates the stock is overvalued and vice versa. Having said that, it relates back to the post where low P/E doesn’t necessarily mean undervalued and the other way around. Hope this helps.