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Ratio analysis tools are used to examine the company’s financial statements and determine the financial health of a particular company. There are various types of ratios used and one of them is a price to earnings ratio (P/E).
The P/E ratio determines the relationship between the company’s stock price and its earnings. PE allows you to invest throughout a market cycle. Let’s look at the pros and cons of the P/E ratio.
Pros:
1. Widely used: The P/E ratio is widely used in the stock market and even for financial stocks like banks and insurance companies.
2. Easy to compute: Price-earnings ratio is very easy to calculate. You only need the share price and the EPS (earning per share).
3. Price of stock: Enable investors to know how much they have to pay for each dollar in return for the stock. They can rely on this information to determine undervalued stocks.
4. Determine growth potential: PE ratios help investors to determine the company’s growth potential before they invest. The ratios show companies that can be affected by dramatic price correction. High PE leads to a selloff of the company whereas low PE shows a sustained growth of the company.
5. Future forecasts: P/E measures the future prospects of a company by taking into consideration the present conditions of the company and comparing it with past performance. It also determines what is being generated for the shareholders.
6. Comparison: PE is used to compare and value companies’ stocks with one another making it a useful analytical tool. It provides context for the company within a specific sector.
7. Make quick decisions: Although the P/E ratio evaluates the worthiness of the company, it can be used to make quick decisions on whether to invest or not.
8. Benchmarking tool: P/E is an excellent benchmarking tool for determining whether the stock is overvalued or undervalued. It also determines the actual expectation of the company.
Cons:
1. No debt/financial structure: Price-earnings does not consider debt/ financial structure when computing the financial statements.
2. Accounting policies: Different accounting policies undermine the comparisons of PE across different companies and countries. These policies include the depreciation methods used, amortization, and tax system.
3. Subjective in nature: The volatile nature of stocks makes it difficult to know what price-earnings we can sell at making P/E subjective in nature.
4. Increased cost risk: The gearing up or share buy-backs can increase the earnings of the company but this can lead to increased cost of risk for it to be achieved.
5. Misleading information: P/E can mislead companies operating on leverage. The periodic inflated earnings through the sale of corporate assets can lead to abnormal earnings. These earnings make the P/E ratio to be unrealistic.
6. Overvalued shares: Investor optimism can lead to inflated stock prices for the entire sector.
During the recession, shares are undervalued in terms of their P/E. During inflation, the earnings of the company are evaluated based on the currency of the specific country and this can increase the P/E.
7. Poor decisions: To achieve the target earnings may lead to poor decisions that affect the business.
8. Not suitable to evaluate losses: Companies making losses cannot use the PE ratio since it can’t determine losses at the early stages of business growth.
9. Historical earnings: P/E earnings are based on historical data and these earnings are difficult to predict since they can’t predict future earnings.
10. Manipulations: Investors tend to over-price the shares if the business and economic environment are facing challenges. This leads to high P/E.
