- Trending Categories
- Data Structure
- Operating System
- MS Excel
- C Programming
- Social Studies
- Fashion Studies
- Legal Studies
- Selected Reading
- UPSC IAS Exams Notes
- Developer's Best Practices
- Questions and Answers
- Effective Resume Writing
- HR Interview Questions
- Computer Glossary
- Who is Who
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.
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.
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.
- Related Articles
- Price-Earnings Ratio vs. Earnings Yield Ratio
- What is the significance of Price-Earnings (PE) ratio?
- What are the Limitations of Ratio Analysis?
- What are the Types of Activity Ratio?
- The price of a chair is reduced by 25%. What is the ratio of(i) Change in price to the old price(ii) Old price to the new price
- The radii of two cylinders are in the ratio $2 : 3$ and their heights are in the ratio $5:3$. Calculate the ratio of their volumes and the ratio of their curved surfaces.
- The diameters of two silver discs are in the ratio 2:3 . What Will be the ratio of their areas
- The ratio of radii of two cylinders is 1:2 and the heights are in the ratio 2:3. The ratio of their volumes is_____.
- The circumference of two circles are in the ratio 2 : 3. Find the ratio of their areas.
- C++ Ratio of Mth and Nth Terms of an A. P. with Given Ratio of Sums
- Find the ratio of expenses to savings if total earnings is Rs. 5000 and expenses is Rs. 3000.
- Volumes of two spheres are in the ratio $64:27$. Find the ratio of their surface area.
- The circumferences of two circles are in the ratio $5:7$, find the ratio between their radii.
- The ratio of the radii of two wheel is 2:5. What is the ratio of their circumferences ?
- What is the Importance of Profitability Ratio?