What is a P/E Ratio? And is it a Useful Metric?

The CEO of Berkshire Hathaway (NYSE:BRK.B) Warren Buffett is commonly referred to as one of the world's most successful investors, but the Oracle of Omaha didn't cut his teeth alone. In fact, Buffett can count the equally respected Benjamin Graham - the 'Father of Value Investing' - as his own personal mentor throughout much of his early career.

Graham, the author of one of our best investing books 'The Intelligent Investor', was an enormously influential figure in the world of investing, and it's probably a sign of his far-reaching influence that we get so many queries about Price to Earnings Ratios (P/E Ratios) from users here at MyWallSt.

Graham is the man most often credited with popularizing the calculation as a benchmark for assessing companies, and some modern investors continue to believe that this ratio is key to unlocking some great stocks.

But the jury is out as to the real effectiveness of this metric. So let's settle it once and for all - does the P/E ratio still hold up as an accurate tool for assessing companies in the modern market?

What's A P/E Ratio?

A P/E ratio is the figure that demonstrates the relationship between a company's stock price and the earnings they post. In other words, it tells us how much people are willing to pay for a share per dollar of earnings made.

To calculate the P/E ratio of a company, you simply divide the stock price by the earnings per share (EPS):

Share Price / EPS = P/E Ratio

or alternatively

Market Cap / Total Earnings = P/E Ratio

So if the share price for a particular company was $30, and their latest EPS was $3 per share, this would give the company a P/E ratio of 10.

But what does the figure '10' mean to us as investors?

In plain English, it can be broadly considered as the number of years it will take for the company to earn back the amount of your original investment - if the earnings were to stay as they currently are (which is highly unlikely, but more on that later).

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So How Do I Use It?

In Graham's time, the main function of the P/E ratio was to help investors determine if a company is overvalued or undervalued in the current market.

P/E ratios typically tended to be lower for more mature companies and higher for high-growth companies (but not always - again, more on that later). For example, General Motors (NYSE:GM) a company at the grand old age of 111 has a P/E ratio of 5.74, while The Trade Desk (NASDAQ:TTD), a company a century younger, has a P/E ratio of 100.7.

So investing in a company with a low P/E was considered quite a safe option as you were expected to recoup your investment in a shorter period of time. In the same way, a company with a high P/E ratio was more of a risk as it was suggested that it could take decades (even centuries!) to reimburse your investment. But these were also the companies liable to undergo explosive growth, so an investment could have seen your returns multiplied many times over if the business was successful.

Today, P/E ratios are used more as a very general indicator of market sentiment towards a particular stock. If the market thinks a company is set for a big future, expect to see a heightened P/E ratio. On the other hand, if there is little growth forecast, the P/E ratio will be low. And if a company has no P/E ratio at all, that means it's not profitable - yet!

But Wait...

Unfortunately, things aren't that simple, and there are various exceptions to the rule that can lead to bad decisions being made.

The P/E ratio is not a cut-and-dried indicator of who you should invest in or not, and there are some severe limitations that all investors should be aware of...

1. Same Same, But Different

P/E ratios are only effective if you use them to compare companies against the average of those in the same sector and of similar positions.

Growth rates and valuations fluctuate massively across different industries. For example, the healthcare sector will go through markedly different cycles than the technology sector, which will itself vary greatly from the food industry.

In addition to this, even companies that do exist in the same space aren't necessarily similar. Booking Holdings (NASDAQ:BKNG) and TripAdvisor (NASDAQ:TRIP) might be counterparts in a similar industry, but Booking's market cap is more than 25 times that of TripAdvisor, so comparing the growth opportunities of these two companies is completely inaccurate.

The P/E ratio is extremely limited in the information it can give unless the two companies being compared are extremely similar in many respects.

2. All Is Not As It Seems...

Non-profitable companies don't have a P/E ratio, so should we ignore them?

Of course we shouldn't. Imagine ignoring companies like Tesla (NASDAQ:TSLA), Slack (NYSE:WORK) or Virgin Galactic (NYSE:SPCE) because they haven't yet turned a profit. Herein lies another major flaw in using the P/E ratio to assess a stock - earnings alone don't give us the full picture of a company.

If earnings reports aren't used in the wider context of other activities the company is involved in, they can end up being completely one-dimensional and not reflective of the underlying opportunity.

For example, company debt could end up completely skewing an analysis if it's not considered with what the company is actually doing behind the scenes. The reporting of heavy debt doesn't factor in the reality that an awful lot of high-growth companies willingly accumulate debt to increase research and development and assure future prospects. Take Netflix (NASDAQ:NFLX) reporting over $12 billion in debt at the end of 2019 as an example of this.

On the flip side, some companies might report phenomenal earnings figures, but what this doesn't tell you is that they aren't reinvesting capital back into the company to future-proof themselves. So while the numbers in the report might look attractive, this investment could burn out in the long-run.

These idiosyncrasies aren't reflected in the P/E ratio - which has just taken the earnings figure as reported.

3. Future Prospects

The most damning limitation of the P/E ratio is its failure to take into account the future prospects of a company.

Earlier, we said that a P/E ratio tells you how many years it will take for you to recoup your investment if everything stays as it is. But I'm sure you don't need us to tell you that nothing stays still in the world of business.

A P/E ratio can only really give you a broad indication of the current relationship between share price and earnings. It will give you no real indication or reliable forecast of future performance.

So What Do I Do?

Investing would be an easy game if all it took was one simple figure to give you the full picture. If that was the case, everyone would do it!

If you're considering a company to invest in, there are a host of factors you should consider - company management, competitive advantages, the wider industry, outstanding debt, etc... The more you think of it, the more laughable it seems that people try to condense the full spectrum of variables down into one number.

To put the inefficacy of P/E ratios into perspective, let's look at some of the powerhouses of industry we all know today.

Companies like Amazon (NASDAQ:AMZN) and Facebook (NASDAQ:FB) have all had ridiculous P/E ratios in the past, but have still performed spectacularly on the market.

In their first year of turning a profit in 2012, Facebook's P/E ratio clocked in at 2500. Amazon had a P/E ratio of 1428.6 in 2013 - which means it would have taken them as many years to recoup your investment if we go by the principles of the ratio. The year before, they didn't even have a P/E ratio, as they weren't profitable in 2012.

But looking at Bezos & Co. now, and we'd be willing to bet that a whole lot of people who had snubbed the stock on the basis of its P/E ratio back then are currently investing heavily in the latest time-travel research.

MyWallSt operates a full disclosure policy. MyWallSt staff currently holds long positions in companies mentioned above. Read our full disclosure policy here.