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Danger of using P/E ratio alone to take investment decision

A.F.M. Mainul Ahsan
The writer is with Texas Tech University, Texas, USA and can be reached at e-mail: mainul.ahsan@ttu.edu
The Financial Times (02.01.2011)

Some investors asked me "what is the best P/E ratio?" to take investment decision in the stock market. And I was also surprised to see investors' "fondness" to P/E ratio rather than firm's financial statements or other factors that define firm's business capability or prospect. In fact, mentionable financial journalists and academicians in Bangladesh frequently depict that price-earnings multiple is everything one need to know to invest in the stock market. The goal of this article is to share some thoughts on P/E multiple for the beginners in stock market in Bangladesh.

P/E ratio is a valuation matrix of a firm's current share price compared to its per-share earnings. For example, if a company's share is currently trading at taka 50 a share and earnings over the last 12 months were Tk 2.0 per share, the P/E ratio for the stock would be 25 (tk.50/tk.2). Theoretically, a share's P/E ratio tells us how much an investor is willing to pay per taka of earnings. In other words, a P/E ratio of 25 suggests that investors are willing to pay Tk. 25 for every Tk.1.0 of earnings that the firm generates. Some investors read a high P/E as an overpriced stock and a low P/E as underpriced, i.e., "a sleeper that the market has overlooked". However, this is a far too simplistic way of explaining the P/E ratio. Why?

There is another interpretation of P/E ratio: the P/E ratio is as a reflection of the market's optimism about a firm's growth prospects. If a firm has a P/E higher than the market or industry average, this could also mean that the market is expecting big things in near future. Similarly, a low P/E ratio does not necessarily mean that a firm is undervalued. Rather, it could indicate a "vote of no confidence" by the market, i.e., the market believes the firm is headed for trouble.

However, analysts report two P/E ratios: Trailing Price-Earnings ratio and Forward (leading) Price-Earnings ratio. Trailing P/E ratio is calculated by taking the current share price and dividing it by the trailing earnings per share for the last 12 months. So, this Trailing P/E ratio is a historic measure. It tells us how long it would take to make back your initial investment in the company if it keeps generating the same earnings that it did in the last year, but there's certainly no guarantee that this will happen.

How will you calculate P/E multiple when a firm had a bad year, i.e. suffered loss? For example, dividing a share price of Tk. 200 by a "current" EPS number of negative Tk. 20 gives a meaningless result of -10. This is why analysts also reports forward (leading) P/E ratio which is calculated by taking the current stock price and dividing it by earnings estimates for the next year. So, forward P/E ratio is helpful in such a situation where a company is emerging from a period of losses. Some critics recommend using earnings/price ratio (E/P) instead of P/E as P/E goes to infinity as earnings (E) go to zero.

In the above situation where firm's earnings are negative, forward P/E could give investors a meaningful result. Forward P/E ratio is calculated by taking the current share price and dividing it by the forecasted earnings per share for the next 12 months. In fact, forward P/E is more useful and informative than trailing P/E. After all, it is the future that counts; you are paying what the company will do in the future rather than what the company did in the past. Unfortunately, print or electronic media in Bangladesh, reports trailing P/E ratios only. To find forward P/E, an investor needs to dig down in the financial statements to forecast firm's revenue and profit. Still an investor should be cautious using forward P/E as most companies increase earnings from year to year, which make the forward P/E almost always lower than the trailing P/E.

Does the difference in P/E ratios alone turn out one company a better investment than the other? Nicholson S F (1960) documented that companies having low P/E ratios on an average subsequently yield higher returns than high P/E companies. Many other researches in different markets also showed that portfolios based on P/E ratio could generate abnormal return. Hence, the extent of market efficiency plays an important role in generating abnormal gain from a portfolio based on P/E ranking. If so, why should we exercise enough caution in using P/E ratio alone in finding an under-priced stock? Since P/E multiple suffers from some serious flaws, if you use P/E alone, you will be surely putting your life-time savings in huge risk.

A P/E matrix by itself does not say much about a share's value. For instance, a P/E ratio of 25 does not mean whole lot by itself; it is neither good nor bad in a vacuum. The P/E ratio only becomes meaningful with context. The most useful way to use a P/E ratio is to compare it with a certain benchmark. Good benchmarks could be the P/E ratio of another company in the same industry, the P/E of the entire industry or market, or the same company's P/E at a different point in time. For example, a company that is trading at a lower P/E than its industry peers could be a good value, but even firms in the same industry can have very different capital structures, risk levels, and growth rates, all of which affect the P/E ratio. All else equal, a firm that has better growth prospects, lower risk, and lower capital reinvestment needs should be rewarded with a higher P/E ratio.

As the overall level of investor confidence changes every year, the average market P/E ratio also varies year by year. Still comparing a firm's current P/E ratio with its historical P/E can also be of value. This is especially true for stable firms that have not undergone major business shifts. If you find a firm that is growing at roughly the same rate with the same business prospects as in the past, but is trading at a lower P/E than its long-term average, you could start thinking of committing some fund in that share. It's possible that the market is simply pricing the shares at an irrationally low level. However, it's also possible that the company's risk level or business outlook has changed, in which case a lower P/E multiple is warranted.

However, an investor needs to remember that using P/E ratios only on a relative basis means that your analysis could be skewed by the benchmark you are using. After all, there will be periods when entire industry or market will become overvalued. For example, in 1996, the whole market was overpriced, and P/Es skyrocketed to its record level in Bangladesh. The DSE All Share Price Index, which was introduced on September 16, 1986 hovered at around 1,000 in June 1996, and reached 3,627 on November 16 the same year. On October 31, 1996, M.B. Pharmaceuticals, Aftab Automobiles, Padma printers had a P/E of 10123, 1386, and 911 respectively! At the market's peak, in 1996, shares were trading at an average of over 80 times of relevant earnings. Bottom line is neither the price of the share nor the benchmark made sense. Thus being less expensive than a benchmark does not necessarily mean that a firm's share is cheap, because the benchmark itself could be vastly overpriced. In addition, the share you are investigating might be growing faster (or slower) than the market or industry or it might be riskier (or less risky). Loosely speaking, comparing a company's P/E ratio with those of industry peers or with the market has some value, but an investor must not rely on these approaches alone to make final buy or sell decisions in the stock market.

Price-Earnings multiple overlooks a firm's growth prospect. Companies in sectors that are growing faster, e.g., telecom in Bangladesh, should warrant a higher P/E. However, low P/E ratio does not necessarily mean the stock is undervalued. For example, company X with a P/E ratio of 15 and 0% earnings growth may not look as alluring as company Y with a P/E ratio of 20 and 25% earnings growth. The reason is if both firms' share prices remain the same, after 3 years, P/E ratio of company Y will decrease to 10.24 while X will still have the same P/E ratio, i.e., 15. So, along with P/E ratio, investors also need to take into accounts future growth rate of a firm. Also, research shows that there is a close positive relationship between a company's market capitalisation and the P/E accorded.

In addition, the denominator part of the equation, i.e., earnings (E) is an accounting figure that can always be twisted, prodded and squeezed into various numbers depending on how you do the math. As we go down in the income statement, firms have more room to twist their numbers. It is easier to manipulate bottom line, i.e., profit, in the income statement comparing to the top line, e.g., revenue. There are different ways firms can manipulate profit figure and thus the P/E ratio. First, firms that have recently sold off part of a business can have an artificially inflated "Earnings" and a lower P/E as a result. In such a situation, you can calculate the firm's P/E based on operating earnings; see whether the stock is cheap or not. Second, reported earnings can sometimes be inflated (or depressed) by one-time accounting charges and gains. As a result, the P/E ratio can be misleadingly high or low.

Third, the volatility, transitory portion of earnings makes the interpretation of P/E difficult for investors. Cyclical firms that go through boom and bust cycles demand a bit more investigation. Although an investor would typically think of a firm with a very low trailing P/E as cheap, this is precisely the wrong time to buy a cyclical firm because it could refer earnings have been very high in the recent past, which in turn means they are likely to fall off soon. Similarly, a cyclical stock is going to look the most expensive when its "Earnings" has bottomed and is about to start growing again. Fourth, management discretion within allowed accounting practices, such as, changing depreciation schedules, LIFO liquidation, impairment charges, bootstrapping, leasing method used can distort reported earnings and thereby lessen the comparability of P/E ratios across firms. In 2009, Whirlpool Corporation's 33% of the EPS came from unusual income tax benefit and changes in depreciation method which is not sustainable and also be considered as a red flag by investors. However, if an investor used P/E ratio alone to value Whirlpool, surely she would have been misguided. Thus, before using P/E ratio alone to take investment decision, investors should be aware of companies' frauds practice in accounting.

So, here are some recommendations to the valued readers to consider few factors before using P/E ratio in their investment decisions. First of all, take into account a firm's growth prospect, i.e., how fast has the company been growing in the past, and are these rates expected to increase, or at least continue, in the future? Second, it is wiser to calculate the P/E using projected EPS, i.e., use Forward Price-Earnings ratio. If projected growth rates don't justify the P/E, then a stock might be overpriced. Third, P/E is only useful to compare companies if they are in the same industry or in the same sector. For example, a bank's P/E ratio should only be compared with other banks not with a utility, textile, food or an IT company. Comparing a pharmaceutical company to a utility is useless. You should only compare one company to others in the same industry, or to the industry average. Lastly and most importantly, investors must be familiar with a firm's accounting practices and should adjust firm's earnings for any of the red flag mentioned above.

While the P/E ratio is a very useful resource, its often-ignored limitations can sometimes trap smart investors off guard. If an investor use P/E carefully and prudently, he will be a lot less likely to fall into any pricey situations. The moral of the story here is to not use P/E ratio alone to take your investment decision in the stock market; don't take any buy or sale decision based on price-earnings multiple alone. While the P/E ratio is one part of the puzzle, it's definitely not a crystal ball. Share analysis demand a great deal more than understanding few simple ratios.

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Congratulations!!!
Very Informative. I think it will be a great help for small investors.