The Defect in Price/Earnings Ratios – Part 1

Tuesday, November 17, 2009

Magnify inverseThe price/earnings ratio (P/E) is a popular stock valuation measure. However, it has a flaw, which I explain below. Tomorrow, in Part 2, we will examine how the flaw affects portfolio and stock market analysis.

First, a word about financial ratios. Many are percents, reflecting proportions, growth, returns, yields and relationships. Their value is in producing measures that can be compared over time and across entities.

The P/E ratio is one of the oddballs. What makes the measure different is that it has price as the numerator. Therefore, its focus is on price per unit of earnings. Compare that to dividend yield (dividends/price), where the focus is on dividend income per unit of price. In fact, a similar relationship is earnings yield (E/P) that can be used instead of P/E.

But, isn’t P/E just the reciprocal of E/P? Yes, and that’s the problem. When examining different earnings levels, it converts the linear earnings yield relationship to a non-linear one. And our minds don’t grasp such measures well. The following graph shows the difference:

PE flaw

This non-linear pattern is especially troublesome in times like the current, when earnings are not at some “normal” level and we are examining different profit projections.

So, use P/E ratios carefully when evaluating or comparing companies in today’s market – and include earnings yield measures to back up your analysis. Tomorrow, we’ll look at the P/E’s problematic effect on portfolio and index analysis.

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