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.