Quoted from the book "Trade like Market Wizards" by Mark Minervini and article "Why The P/E Ratio Is Useless – And How To Calculate EV" by Jason Rivera
"It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price" - Warren Buffett
In the stock market, what appears cheap could actually be expensive and what looks expensive or too high may turn out to be the next super-performance stock.
The P/E ratio is two components. P is price per share and E is earnings per share.
For example, if a company is currently trading at $43 a share and earnings over the last 12 months were $1.95 per share, the P/E ratio for the stock would be 22.05 ($43/$1.95).
Below are examples I made up to illustrate why P/E is a useless metric.
On a P/E basis company one looks better right? But what happens when you add in important things like cash and debt to the equation?
Which company would you rather buy now? The company with a lot of net debt or the company with a lot of net cash?
But this isn't the only reason P/E is misleading...
Earnings Are Easy To Manipulate
The E in the P/E equation is earnings like I showed above. Another reason I don't like P/E is because earnings are easier to manipulate than EBIT, FCF, and owner's earnings.
The earnings part of P/E is after all costs, taxes, and expenditures. EBIT, FCF, and OE are all after costs and expenditures but before taxes. Another way companies can manipulate earnings is with the tax rate the company states it has to pay.
The standard P/E ratio reflects historical results and does not take into account the most important element for stock price appreciation: the FUTURE
Because P/E is a ratio, its value will be affected if either the numerator or denominator changes. Both numbers, however, can be moving targets, particular when a company has good potential for increasing its earnings and also is attracting buyers who are accumulating the stock, which pushes the price higher.
In many cases, stocks with super-performance potential will sell at what appears to be unreasonably high P/E ratio. The really exciting, fast-growing companies with big potential are NOT going to be found in the bargain bin.
Many super-performance stocks tend to move to EXTREME VALUATIONS and leave analysts in awe as their prices continue to climb into the stratosphere in spite of what appears to be a RIDICULOUS valuation.
Historical study of super-performance stocks shows that the average P/E increased between 100% and 200% on average (2 to 3 times) from the beginning until the end of major price moves.
Buying Low and Selling High has little to do with the current stock price. How High or Low the price is relative to where it WAS previously is NOT the determining factor in whether a stock will go HIGHER still.
"There's a reason a FERRARI costs more than a HYUNDAI"
Savvy growth players know that you often have to pay more for the best goods in the market.
Remember, the MARKET is a DISCOUNTING mechanism that trades on the FUTURE, not the PAST.
By themselves, P/E ratio aren't very helpful in determining the POTENTIAL direction of a stock's price. The P/E ration tells you what the market is willing to pay for a company's earnings at the CURRENT time.
I use the P/E ratio as a SENTIMENT GAUGE that gives me some perspective about investor EXPECTATION. Generally, a High P/E means there are High Expectations and a Low P/E means there are Lower Expectations.
The current P/E ratio at which a company trades is only a MINOR consideration compared with the potential for earnings growth. Growth stocks are driven by GROWTH.