We like price/earnings (p/e) ratios. They can give a clear, simple view of whether a share is a bargain buy, or an overpriced sell. However, it's sometimes dangerous to take ratios at face value. Here are three traps to watch out for.
Data quality or lack of it can be a problem. The p/e is the current share price divided by annual earnings. If you use last year's profit figure on the basis that it is known, the ratio is out of date. Yet use a more relevant estimate of future earnings and you are relying on your ability to predict the future. And even if you could get it spot on, is one year's earnings a true reflection of a firm's underlying profitability?
A Shiller p/e that uses an average earnings figure derived from the last ten years is a better bet, but it will only be available for a well-established firm. So no version of the p/e ratio is perfect.
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Remember too that no ratio in isolation reveals very much about risk. A firm might have a low p/e because it is an underappreciated bargain. But it could also have a low rating because it is heavily indebted (geared), or carries other hidden risks, such as unsettled court disputes. You can't tell just by using the p/e. So use a combination of ratios (see my video guide six numbers every investor should know).
Lastly, a p/e may be misleading or useless where earnings are very low or non-existent. It's also less relevant in sectors where earnings are not the key driver of share prices. Investment trusts and property firms (where asset prices matter more) are good examples. So while the p/e is a good place to start, your analysis needs to go a lot deeper if you are to be a successful investor.
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