Pros and cons of Price-to-Earnings (PE) ratio

Posted On: 22 October 2023

The Price-to-Earnings Ratio, simply known as PE Ratio, is a popular metric in investment analysis. The PE ratio is used to assess the relative attractiveness of a stock based on its current price relative to the company’s earnings.

PE Ratio was popularised by Benjamin Graham, the legendary British-born American investor and author of the best-selling book on investing: ‘The Intelligent Investor’. Graham advocated ‘value investing’ and looking for price-value discrepancies to find out when the price of a stock is lower than its intrinsic value. Calculating the PE Ratio before deciding where to invest can help you in this endeavour.

There are many pros and cons of PE ratio in investment analysis. Understanding them will help you learn about to know how to use this metric properly for investment analysis.

Table of contents

Advantages of using price-to-earnings (PE) ratio
Disadvantages of using the PE ratio

Advantages of using price-to-earnings (PE) ratio

Here are the benefits of using PE ratio for investment analysis:

Easy to calculate: The formula for calculating the Price-to-Earnings (PE) Ratio is fairly simple. Just by using the stock price and earnings-per-share of a company, you can calculate the PE ratio of the stock. The ease of calculation is one of the main reasons why PE Ratio is so popular despite the availability of a wide range of other metrics for investment analysis.
Simple to use: The PE ratio is not just easy to calculate but easy to use, too. Whether you get a high value or low value, you can determine the viability of the investment right away. Since the PE ratio helps you gauge the real-life performance of a company to make an investment – instead of trying to understand the ever-changing market sentiment – you can potentially get better results from your investment.
Helps identify growth potential: If the PE ratio is high, it indicates one of the two possibilities: the stock is overvalued, or the company is on a growth trajectory.
PE ratio is low, it indicates one of the two possibilities: the stock is undervalued, or the company’s performance is declining. With a little more research, you can easily find out which of the two possibilities is more viable and make an investment decision.
Helps compare against other stocks in the industry: If you are seeking investment opportunities within the same industry, you can choose stocks with a lower PE ratio as it indicates that the stock is undervalued at the time.

Disadvantages of using price-to-earnings (PE) ratio

Now that you know about the advantages of PE ratio, it is time to look at the disadvantages to understand all the pros and cons of PE Ratio:

Does not include company debt: One of the most important points you must keep in mind when considering the pros and cons of PE ratio is that it does not take the company’s debt into consideration. This is because the balance sheet does not factor anywhere in PE ratio. Therefore, a low PE ratio may not indicate that the stock is undervalued; instead, it may point to the fact that the company has a large debt and may be close to bankruptcy.
May lead to missed investment opportunities: Some companies invest money to expand their operations but have no earnings. In such cases, the PE ratio cannot be determined because of the unavailability of the main component of calculating it (i.e., the earnings). But the investment opportunity still exists. Thus, if you only use PE ratio to make investment decisions, you might miss out on such investment opportunities.
Cannot be taken at face value: If a company sells assets and records it as revenue, this could affect the PE ratio by inflating the company’s earnings. This possibility of manipulation is why other metrics need to be used in addition to PE ratio to arrive at a sound investment decision.

Conclusion

In conclusion, PE ratio is easy to calculate and helps filter out a vast number of stocks when making an investment decision. It enables you to quickly shortlist a few potentially undervalued stocks – i.e., stocks with a low PE ratio from a big list. However, it is important to remember that there is no single metric, including PE ratio, that can be considered perfect for identifying investment opportunities. You must use different metrics for investment analysis to be able to make sound investment decisions.

FAQs

What Is a good PE ratio? Is high or low better?
What would qualify as a good PE ratio depends on industry and market conditions. Generally, a lower PE ratio suggests a stock is undervalued, offering potential for growth, while a higher PE ratio indicates overvaluation or high growth expectations.
High-growth sectors might have higher PE ratios, reflecting future growth potential. Therefore, comparisons should be made within the same industry. Overall, a lower PE is better for value investors seeking bargains, while a higher PE can be attractive for growth investors anticipating significant earnings increases.

How useful is PE ratio?
The PE ratio can help investors determine if a stock is overvalued, undervalued or fairly valued. A lower PE ratio might indicate an undervalued stock, while a higher PE ratio may either suggest overvaluation or indicate positive market sentiment and strong growth prospects for a particular company. PE ratios can be useful for investors to compare stocks within the same industry to identify the best investment opportunities.
However, the PE ratio should not be used in isolation. It is most effective when combined with other financial metrics and qualitative factors to provide a comprehensive view of a company's performance and potential.

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