5 Common Misuse of P/E Ratio

Price Earning (P / E) ratio is the ratio most commonly used in investing. Searching the term 'P / E ratios in Google will yield 2.3 million results. Quite simply, P / E ratio is the ratio of stock price divided by earnings per share (EPS). If a company A is trading at $ 10 per share and earns $ 2.00 per share, then A has P / E ratio of 5. This means that it takes 5 years to pay for your initial investment. For the profit of the company If you invert P / E ratio, we get E / P ratio, which is the return on our investment. In this case, a P / E of 5 is equal to a yield of 20%.

P / E ratio is convenient and very easy to use. But that is why so many investors abuses. Here are some common abuse of P / E ratio:

Using trailing P / E. Trailing P / E is the price earning ratio of a company for the past 12 months. For cyclical companies from a peak in earning, P / E ratio is misleading. Trailing P / E ratio may seem low, but its forward P / no. E Forward P / E is calculated using the expected earnings per share of a company. Use Forward P / E is more important than the trailing P / E. After all, it is the future that counts.

Earning negligible growth. Low P / E ratio does not necessarily mean that the stock is undervalued. Investors should take into account the growth of a company. A company with a P / E ratio of 15 and 0% earning growth may not be as attractive as Company B money with a P / E ratio of 20 and 25% of growth. The reason is if both stock prices remain the same, after 3 years, P / E ratio of company B decrease to 10.3, while A will still have a P / E ratio of 15. The moral of the story here is to P / E ratio alone can not be used to assess. The value of an asset

Ignoring One-Time Event. P / E ratio is always included one-time event, such as restructuring costs or downward adjustments to goodwill. If that happens, the "E" appear in the P / E ratio is low. As a result, this event blows P / E ratio. Investors will do well ignore this one-time event and look beyond the high P / E ratio.

Ignoring Balance. That's right. Investors often ignore the cash and long-term liabilities embedded in the balance sheet in the calculation of P / E ratio. The truth is, companies with higher net cash on their balance sheets usually get higher P / E valuation.

Ignoring Interest Rate. Only as P / E ratio for our investment decisions will produce disastrous results. As explained earlier, if we invert P / E ratio, we get E / P ratio. E / P ratio is essentially the return on our investment. Stock with a P / E ratio of 10 is thus 10%. Stock with P / E of 20 is to give 5% and so on. If interest rates rise to 6%, than on shares in P / E of 20 will be appreciated, everything else remains the same.

As with other financial ratios, P / E ratio can not be used solely to the value of a company. Rate fluctuates, earnings per share goes up and down and it does share. All these must be considered when choosing your potential investment into account.

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