Why P/E Ratios Can Be Misleading

03/25/2011 12:01 am EST


Price/earnings (P/E) ratio is widely used to gauge a stock's value, but closer study shows that another ratio—price/earnings growth (PEG)—gives a more complete and accurate reading.

It is common practice for investors and traders to use the price-to-earnings ratio (P/E ratio, or price multiple) to determine if a company's stock price is over- or undervalued. Companies with a high P/E ratio are typically growth stocks. However, relatively high multiples do not necessarily mean stocks are overpriced and not good buys for the long term.

Let's take a closer look at the P/E ratio formula:

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There are two primary components here, the market value (price) of the stock and the earnings of the company. Earnings are very important to consider. After all, earnings represent profits, and that's what every business strives for. Earnings are calculated by taking the hard figures into account: revenue, cost of goods sold (COGS), salaries, rent, etc.

These are all important to the livelihood of a company. If the company isn't using its resources effectively, it will not have positive earnings, and problems will eventually arise. Learn more about how to use the price-to-earnings ratio to reveal a stocks real market value.

Besides earnings, there are other factors that affect the value of a stock. For example:

  • Brand - The name of a product or company has value. Established brands such as Procter & Gamble (PG) are worth billions

  • Human Capital - Now more than ever, a company's employees and their expertise are thought to add value to the company

  • Expectations - The stock market is forward looking. You buy a stock because of high expectations for strong profits, not because of past achievements

  • Barriers to Entry - For a company to be successful in the long run, it must have strategies to keep competitors from entering the industry. For example, most anyone can make a soda, but marketing and distributing that beverage on the same level as Coca-Cola (KO) is very costly.

All these factors will affect a company's earnings growth rate. Because the P/E ratio uses past earnings (trailing 12 months), it gives a less-accurate reflection of growth potential.

The relationship between the price/earnings ratio and earnings growth tells a more complete story than the P/E on its own. This is called the PEG (price/earnings growth) ratio and is formulated as:

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Looking at the PEG value of companies is similar to looking at the P/E ratio: A lower PEG means the stock is more undervalued.

Comparative Value

Let's demonstrate the PEG ratio with an example. Say you are interested in buying stock in one of two companies. The first is a networking company with 20% annual growth in net income and a P/E ratio of 50. The second company is in the beer-brewing business. It has lower earnings growth at 10% and its P/E ratio is also relatively low at 15. (There are many other common ratios to use when comparing stocks, such as the price-to-sales (P/S) ratio.)

Many investors justify the stock valuations of tech companies by relying on the assumption that these companies have enormous growth potential. Can we do the same in our example?

1) Networking Company:

  • P/E ratio (50) divided by the annual earnings growth rate (20) = PEG ratio of 2.5

2) Beer Company:

  • P/E ratio (15) divided by the annual earnings growth rate (10) = PEG ratio of 1.5

The PEG ratio shows us that, when compared to the beer company, the always-popular tech company doesn't have the growth rate to justify its higher P/E, and its stock price appears overvalued. 

The Bottom Line

Subjecting the traditional P/E ratio to the impact of future earnings growth produces the more informative PEG ratio. The PEG ratio provides more insight about a stock's current valuation. By providing a forward-looking perspective, the PEG is a valuable evaluative tool for investors attempting to discern a stock's future prospects.

By the Staff at Investopedia.com
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