The price-to-earnings (P/E) ratio is a fairly simple tool for assessing company value. Judging by how often the P/E ratio gets touted—by Wall Street analysts, the financial media and colleagues at the office water cooler—it's tempting to think it's a foolproof tool for making wise stock investment choices. Think again—the P/E ratio is not always reliable. There are plenty of reasons to be wary of P/E-based stock valuations. (See also: 澳洲幸运5官方开奖结果体彩网:Financial Ratios.)

Calculating the P/E Ratio: A Quick Review

On the surface, calculating price to earnings is fairly straightforward. The first step in generating a P/E ratio is to calculate 澳洲幸运5官方开奖结果体彩网:earnings per share (EPS). Typically, EPS e𝓰quals the company's after-tax profits divided by the number of shares in issue♉.

 $EPS = \frac{\text{Post-Tax Profits}}{\text{Number of Shares}}$EPS=Number of SharesPost-Tax Profits​

From the EPS, we can calculate the P/E ratio. The P/E ratio equals the company's current 澳洲幸运5官方开奖结果体彩网:market share price divided by the ea🌱rnings per share for the previous year.

 $\frac{P}{E}\ =\ \frac{\text{Share Price}}{\text{EPS}}$EP​ = EPSShare Price​

The P/E ratio is supposed to tell investors how many years' worth of current earnings a company will need to produce in order to arrive at its current market share value. So, let's say the imaginary company Widget Corp. earned $1 per share over the past year and it's trading at $10.00 per share. The P/E ratio would be $10/$1 = 10. What this tells us is that the 澳洲幸运5官方开奖结果体彩网:market prices it at 10🍷 times earnings. Or in other words, for every share purchased, it will take 10 years of cumulative earnings to equate to the current share price. Naturally, investors want to be able to buy more earnings for every dollar they pay, so the lower the P/E ratio, the less expensive the stock.

The ratio sounds simple enough, but let's look at some of the dangers associated with 澳洲幸运5官方开奖结果体彩网:taking P/E ratios at face value.

The first part of the P/E equation—price—is straightforward. We can be fairly confiden🐽t what the market price is. On the other hand, coming up with an appropriate earnings number can be tricky. You have to make a lot of decisions how to define earnings.

What's In Those Earnings?

For starters, earnings aren't always clear cut. Earnings can be affected by unusual gains or losses which sometimes obscure the true nature of the earnings metric. What's more, reported earnings can be manipulated by company management to meet earnings expectations, while 澳洲幸运5官方开奖结果体彩网:creative accounting choices—shifting 澳洲幸运5官方开奖结果体彩网:depreciation policies or adding or subtracting 澳洲幸运5官方开奖结果体彩网:non-recurring gains and expenses—can make 澳洲幸运5官方开奖结果体彩网:bottom line earnings numbers bigger and, in turn, P/E ratios, smaller and the stock appear less expensive. Investors need to be wary of how companies arrive at their repo❀rted EPS numbers. Appropriate adjustments often have to be done in order to obtain a more accurate measure of earnings than what is reported on the balan💧ce sheet.

Trailing or Forward Earnings?

Then there is the matter of whether to use trailing earnings or 澳洲幸运5官方开奖结果体彩网:forward earnings figures.

Located right in the company's latest published 澳洲幸运5官方开奖结果体彩网:income statement, historic earnings are easy to find. Unfortunately, they are not much use for investors, since they say very little about what earnings are in store for the year and years ahead. I🍌t's the company's future earnings that investors are interested𒁏 in most since as they reflect a stock's future prospects.

Forward earnings (also called future earnings) are based on the opinions of 澳洲幸运5官方开奖结果体彩网:Wall Street analysts. Ana🌟lysts, if anything, typ𝓰ically tend to be overoptimistic in their assumptions and educated guesses. At the end of the day, forward earnings suffer the problem of being a lot more useful than historic earnings but prone to inaccuracies.

What About Growth?

The biggest limitation of the P/E ratio: It tells investors next to nothing about the company's EPS growth prospects. If the company is growing quickly, you will be comfortable buying it even it had a high P/E ratio, knowing that growth in EPS will bring the P/E back down to a lower level. If it isn't growing quickly, you might shop around for a stock with a lower P/E ratio. It is often difficult to tell if a high P/E multiple is the result of expected growth or if the stock is simply 澳洲幸运5官方开奖结果体彩网:overvalued.

A P/E ratio, even one calculated using a forward 澳洲幸运5官方开奖结果体彩网:earnings estimate, doesn't always tell you whether or not the P/E is appropriate to the company's forecasted growth rate. So, to address this limitation, we turn to another ratio, the 澳洲幸运5官方开奖结果体彩网:PEG ratio:

 $\text{PEG}\ =\ \frac{\text{P/E}}{\text{Forecast EPS Growth Rate Over the Next 12 Months}}$PEG = Forecast&🍸nbsp;EPS&n🌳bsp;Growth Rate Over the Next 12 MonthsP/E​

In a nutshell, the lower the PEG ratio, the better. A PEG of 1 suggests that the P/E is in line with growth; below 1 implies that you are buying EPS growth for relatively little; a PEG greater than 1 could mean the stock is overpriced. However, even when the P/E ratio is standardized for growth, you are basing your investment decision on outside estimates, which may be wrong. (See also: 澳洲幸运5官方开奖结果体彩网:PEG Ratio Nails Down Value Stocks.)

What About Debt?

Finally, there's the tricky issue of a company's debt load. The P/E ratio does nothing to factor in the amount of debt that a company carries on its 澳洲幸运5官方开奖结果体彩网:balance sheet. Debt levels have an impact on 澳洲幸运5官方开奖结果体彩网:financial performance and valuation, yet the P/E doesn't allow investors to make apples-to-apples comparisons between debt-free firms and those bogged down with 🌸outstanding loans and liabilities.

One way to address this limitation is to consider a company's 澳洲幸运5官方开奖结果体彩网:enterprise value or EV in place of its Price (P).

 $\begin{aligned} &\text{(Simplified) } EV \ =\ \text{MC}\ +\ \text{Net Debt}\\ &\textbf{where:}\\ &MC\ =\ \text{Market capitalization} \end{aligned}$​(Simplified) EV = MC + Net Debtwhere:​

Let's say the Widget Corp., with a market share price of $10 per share, also carried the equivalent of $3 per share of net debt on its balance sheet. The company, then, would have 澳洲幸运5官方开奖结果体彩网:total enterprise value of $13 per share. If Widget Corp. produced EPS this year of $1, its P/E ratio would be 10. But more sophisticated investors would perform the calculation with enterprise value in the numerator and 澳洲幸运5官方开奖结果体彩网:EBITDA in the denominator.

The Bottom Line

Sure, the P/E ratio is popular and easy to calculate. But it has big shortcomings that investors need to consider when using it to assess stock values. Use it c🧸arefully. No single ratio can tell you all you need to know about a stock. Be sure to use a variety of ratios to gไet a fuller picture of financial performance and stock valuation.