Putting P/E ratio into perspective

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.

Author: Sudhan P

I simplify investing concepts to help you navigate the stock market jungle.

2 thoughts on “Putting P/E ratio into perspective”

  1. Hi FF now,

    You cover almost everything relating to P/E.
    Quite super!
    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?

    1. Thanks temperament!

      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.

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