Why you can’t rely on the p/e ratio alone

It'd be brilliant if just one number could definitively tell you whether or not to buy a stock.

And for many people, that number is the p/e (price/earnings) ratio. It's simple to calculate, it's easy to understand, and it's about as in-depth as they can be bothered to go with share analysis.

The trouble is, while it's a handy tool, there's a lot more to picking stocks than just this one number or any single number for that matter.

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Yes, a high or low p/e can tell you whether or not a stock looks cheap or expensive compared to its sector, or to another stock.

But alone, it can't tell you whether a stock is good value in other words, whether you should buy it or not. A cheap-looking stock might have a low p/e ratio for a good reason. And an expensive-looking stock might deserve its high p/e ratio.

In order to get a fuller picture you'll need to be armed with some other information, and a few more ratios too. We'll cover these in later emails, but for now here are a few of the p/e ratio's weaknesses.

How reliable is e'?

The first potential problem with a p/e is the e' the earnings figure.

The p' is known. The share price can't be argued with. But earnings are more subjective.

You can use the past 12 months' earnings. In that case you know for sure that this is the amount the company made. But you don't know whether last year's earnings are necessarily any guide to the future.

For example, I've just looked at the MoneyWeek FTSE share performance table for the FTSE 100, and sorted it in ascending order of p/e.

Today (I'm writing this on 14th September 2012), a company with one of the lowest p/es in the FTSE 100 is Eurasian Natural Resources Corp (ENRC). Sounds good.

Trouble is, ENRC is a miner. Miners make lots of money when commodity prices are high. But if commodity prices fall, their earnings collapse too.

We're currently at a stage in the mining cycle where miners are still spending a lot of money on mining, but commodity prices are falling. So profits are heading for a tumble.

So ENRC has a low p/e because investors suspect that last year's earnings won't be sustained this year. This is a constant problem with businesses in cyclical' (ie, boom and bust) industries.

If you don't want to use the historic earnings, you can usually find a future' or prospective' p/e ratio instead. This compares the current share price to an estimate of the following year's earnings.

So for example, if you're looking on websites or in the papers, the numbers you'll currently see quoted are p/e ratios for 2012 and forward' p/e ratios for 2013. In the latter case, an analyst is estimating earnings for a 12-month period that has not yet started.

You can probably already see the problem. How can anyone predict future earnings with any accuracy?

Given the vagaries of the economy, it can be tough to predict earnings even a few months ahead, let alone any further. For example, shares in Burberry just collapsed by 20% after it issued a profit warning that clearly took the market by surprise.

What about risk?

Another problem with the p/e ratio is it doesn't really tell you anything about how risky the firm you are investing in is.

A low p/e is better than a high p/e in that it offers more scope for share price growth. But it may also hide a few problems that could trap an unwary investor.

For example, in general, smaller companies are riskier than larger companies, because they tend to be more prone to going bust. So a £50m company on a p/e of five might look cheaper than a multi-billion pound FTSE 100 stock on a p/e of ten. But without knowing the size of the companies, you have no way of knowing that the former company is probably a lot riskier than the latter.

Next there's the problem of hidden debt. A firm with a low p/e might have a low p/e because it is carrying lots of debt on its balance sheet. Debt makes a company riskier for shareholders, because interest on debt usually has to be paid to lenders come what may. People who are owed money by the company get paid before shareholders.

So a firm with lots of debt will tend to hit cash flow problems faster than one with low debt. Once again the p/e ratio alone won't give you any idea of how indebted a company is.

Lastly on the subject of risk, a p/e doesn't tell you anything about a firm's commercial vulnerability. We're talking about less tangible things here, such as the strength (or otherwise) of its management team, how competitive its market is, and so on.

You don't want to buy a supposedly cheap share relying on a p/e ratio only to find that it is cheap because its best days are behind it and it faces all kinds of competitive threats.

A good current example of this is AstraZeneca. The drug giant has struggled to find profitable new drugs, while its big blockbusters are being attacked from all sides by generic products from rival manufacturers.

Astra might make a comeback, but for now, these problems have left it on a p/e of around six while its currently more successful rival GlaxoSmithKline is on a p/e of over 12.

Other flaws in the p/e ratio

P/e ratios only measure reported profits. They don't tell you anything about cash flow. Believe it or not, cash and profits are not the same thing in many cases the two figures are completely different.

You could sell a lot of goods on credit for example. The paper profit you made on the sale would go down as a profit in your accounts. But you might not get the actual cash for that sale until much later in the year.

Small firms in particular, often go bust because while they are profitable on paper, there's no actual money coming in the door. So you could conceivably buy an attractive-looking low p/e stock, only for it to go bust the next day for lack of cash. So you need other tools to measure cash flow.

Also, another obvious problem with the p/e is that it simply isn't the right ratio to use for some stocks. Often early stage companies make no profits at all. In this case, the p/e ratio can't be calculated there's no e' number to use.

In other sectors, there are better ways to compare firms. For example, the success and performance of investment trusts or property investment firms is driven much more by the size of their portfolio and the value of their underlying assets, than it is by pure earnings. So it makes sense to use other ratios that focus on these to compare them.

A p/e ratio is a good first step, but it's not definitive

We're not saying there's no value in working out the p/e. It can be a good way to spot a company that's worth investigating further. You just need to be aware of its limitations.

With that in mind, here's a bit of homework.

Kazakhmys is a mining stock. At the time of writing, it trades on an historic p/e of four. Fresnillo is also a mining stock. But it trades on an historic p/e of 25.

What does this say about investor expectations for the two companies? And why do you think the p/e ratios are at these such different levels, even although they're both miners?