The Virgin Investor will come across the price-earnings ratio quite frequently on the road to returns. This is an often quoted ratio that shows:
Market value per share / Earnings per share
It is also really easy to fall into the trap of thinking that the lower the PE ratio, the higher the earnings per share when compared to market value of the share, therefore the more investable the share is. As always in the world of investing, it is not that simple. Here are 3 limitations that should be considered when comparing the price-earnings ratio of different companies.
Comparisons should only be made between companies in the same industry
Valuations of companies in different industries could vary wildly depending on how the market views the industry in a number of different of factors – from political and macro-economic factors such as exchange rates to more industry specific factors such as perceived growth.
This means different industries will have different expectations as to what an attractive PE ratio looks like. To mitigate against this, compare the PE ratio between companies in the same industry only.
A company’s quality of reported earnings should be considered when using the PE ratio
Company earnings can be a subjective measure influenced by interpretation of accounting treatment. Therefore when comparing PE ratios calculated from a company’s earnings, a company which is pushing to report higher earnings (to maximise financial performance) will have an artificially lower PE ratio and a company that is pushing to report lower earnings (to minimise the corporation tax bill) will have an artificially higher PE ratio.
Therefore particular attention should be paid to ensuring that the quality of reported earnings are consistent between companies that are being compared.
Ultimately, the price earnings ratio is based on a share price which is the market’s perceived value of a company and earnings that are backwards facing
The PE ratio is in no way an accurate forward looking view of how a company will perform. For one, the share price is nothing more than the perceived market value today and will move daily dependent on a huge variety of internal and external factors. Secondly, the reported earnings figure used will likely be from previous quarterly results (ie. backwards facing) and again is not representative of what will happen in the future.
The PE ratio offers a very quick comparison between companies in the same industry, as to whether their shares are significantly under or overvalued when compared to the rest of the industry. Before using this ratio to make investment decisions, it is important that the above considerations are factored in and to remember that metrics based on past performance may not accurately predict what is going to happen.