Successful investing is all about finding the best stocks for the lowest price. Although something as complex as a business can never be reduced to just one 'magic' number, the price-to-earnings (p/e) ratio can reveal when a share is a bargain and when it's overpriced. So it's a great place to start your hunt. But what is it and exactly what can it tell you?
However, there are drawbacks; conventional p/es can let you down in four ways.
A single-year p/e ratio is a snapshot based on one year's earnings. That makes it an unreliable guide to future performance for a cyclical firm with volatile profits. The Shiller p/e which recognises the fact that one year's earnings may not represent a firm's true profitability find out more about the Shiller p/e here.
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Although the p/e ratio can be a useful snapshot revealing whether a share is cheap or expensive in relation to earnings, critics argue that what matters more is how much you are paying for future earnings growth. That's what the 'price to earnings growth ratio' (PEG) tries to capture.
Earnings aren't equally important in analysing all industries. In investment trust or property sectors, net assets under management tend to matter more. That means other ratios, such as the price/book ratio (the share price as a multiple of the book value of a firm's assets per share), are more relevant.
The p/e ratio tells you nothing about cash flow and hence dividends. Profitable firms that don't manage their cash flow properly can go bust a p/e ratio may give you little advanced warning. The ratio also reveals nothing about the proportion of annual profits paid out as a dividend, or whether current dividend policy can be maintained. However two other ratios can help answer these questions.
It is a hopeless measure for a firm making losses, as you have no earnings figure available. It is also prone to being distorted by subjective accounting rules in particular those that deal with how the cost of long-term assets is charged against profits. Analysts try to correct for these weaknesses by looking at other measures. One very popular one is EV/ebitda.
See also What does a p/e ratio really tell you?"
No single ratio is perfect. But the p/e is a vital tool for a beginner and a key part of any investor's tool kit.
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