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# What are the pitfalls of the Price Earnings Ratio (P/E Ratio)?

## Not Cash Earnings

The biggest and, by far, the most prominent disadvantage of the P/E ratio is that the earnings it shows are the accounting earnings. These earnings are defined by the accounting standards of specific standards for a particular country. The earnings are not the cash earnings of the firm. In fact, many companies in the stock exchange report profits but gain no cash actually.

## Not Easy to Estimate the Value of a Company

Another problem with the P/E assumption is that the earnings stay the same for a considerable time in the future. So, if a company is trading at 10 times the P/E ratio, the investors will think that earnings stay intact for the next 10 years!

For an investor who has considerable experience, assuming the earnings is easy. But, estimating the value of a company’s shares a year or two into the future is extremely difficult, so 10 years into the future is even more complex.

## Completely Theoretical

The other problem with the P/E ratio is that 15 times is pricier than 10 times earnings. The anticipation that a company will earn its present earnings for the next 10 years and an investor will receive the money-back is completely theoretical.

A company's earnings may go up or down significantly over the following 10 years. It is easy to realize that investors should prefer to own stocks of a company whose earnings go up significantly over the next 10 years. The P/E ratio cannot tell anything about that.

## Silent about the Balance Sheet

The P/E ratio is silent about the balance sheet of a company. A company trading at a 2 times P/E can be incredibly expensive if the company has a large current debt that it has no way of paying, so, the company may become bankrupt in the current financial year.

**Note** − The recent global financial crisis shows many examples of companies where the PE ratio is high but the company’s fundamentals are weak.

If we go by P/E ratio, then a company trading at 8 times PE earnings can be declared cheaper than a company trading at 16 times earnings. Upon closer inspection, we discover that the company trading at 8 times earnings gave a one-time profit never to be repeated while that the company at 16 times earnings shows 20% annual earnings growth for the past 10 years.

After considering these issues, the company at a 16 times P/E multiple will actually be a more intelligent investment than the company at 8 times P/E multiple.

## Conclusion

The P/E ratio, despite having these disadvantages, still has a place in valuing stocks. Investors need to consider other valuation methods, to check a company’s present condition.

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