Why the Price Earnings Ratio is meaningless

by FloydMCD

I know I chose a rather offensive title for a lot of low PE Investors but let me explain a bit more why.

The Price Earnings Ratio is meaningless BY ITSELF.

I’m afraid too many People focus on a low Pe. They run their scanners when they are looking for investment opportunities and then when they find a PE of 5 they think they found the holy grail.Here are a few things that the PE won’t tell you

Worst of all :
“Profits are an opinion, Cash is a fact” – Alfred Rappaport

Are Profits really Profits?
Basically the management team has a lot of room to manipulate Earnings. It’s actually possible to be “profitable” but cash is flowing out of the company year after year. The “Profits” could be very misleading. Always compare the cashflows with the net profits they claim to make!

The Company could have a lot of debt and it’s possible they can’t manage it!
The Price earnings ratio is based on Market cap and does not include the debt. Always look at the Enterprise Value to see the real price of a Company!

Sales and Earnings could be declining
A really bad scenario would be if a company keeps making less money year after year. Within a few years a low PE would turn into a high PE ( assuming the price is constant). This is not a scenario that you want and it would turn a cheap stock into a quite expensive stock

There was a one off event
A one off Event is an event that occurs once and then it won’t repeat. Profits could’ve been higher last year because the Company sold an asset. It depends how they book it BUT it’s likely that it will distort the Price earnings ratio for that period. Even worse. If they sold parts of their company they will likely earn less money in the future. Once again this is not a scenario that you want!

READ  These 3 Industries Tanked S&P Earnings

The Company could face expensive lawsuits
Another thing the PE doesn’t tell you is that the company might face huge fines in the near future. Did they put the money aside already ? If not it can hurt earnings

The company could have declining Margins
Another thing the Price Earnings Ratio won’t tell you are if Margins are declining. This could be because of new competition etc. Once again a bad scenario that will turn a low PE into a high PE stock over some time

Can you think of other reasons why the PE could be misleading? I am looking forward to your comments.