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What the Price to Earnings Ratio Is Not Telling You

The price to earnings ratio (P/E Ratio) is one of the easiest methods investors can use to value a company. It is simple to calculate – you divide a company’s share price with its earnings per share – and most finance websites such as Yahoo! Finance and Bloomberg will provide you with ready ratios at the click of your mouse.

But, is having the P/E ratio alone sufficient to make an investment decision? Let’s look at some of the myths surrounding P/E ratios.

Possible distortion to the P/E ratio

In the calculation of the P/E ratio, the net income of a company is typically used, which might result in counting non-recurring incomes such as fair value gains and disposal gains.

For example, in commodities trader Olam International’s (SGX: O32) income statement, it has to declare “net gain from changes in fair value of biological assets” as one of the line items. In the past, the company used to declare non-operational changes to the fair value of its biological assets as part of that line item. These non-operational changes arose due to changes in the fair value model used by the company and can distort the real earnings power coming from Olam’s core business.

Similarly, property counters such as the real estate investment trust, CapitaMall Trust (SGX: C38U), has to revalue its investment properties yearly and such revaluations can cause distortion to its core earnings too. Therefore, it is important for investors to not just look at the P/E ratio on the surface but rather, delve into the actual drivers of the company’s earnings.

Is a low P/E always better than a high P/E?

It is also a myth that a low P/E automatically signifies a better bargain as compared to a company trading at a higher P/E. The market is highly efficient in its pricing and most low P/E stocks are “cheap” for a reason. In most cases, high P/E companies tend to have better growth prospects and might even outperform in the long run. One such example of this is Raffles Medical Group (SGX: R01). The healthcare operator has been trading at a high P/E ratio most of the time since its initial public offering in 1997. However, over the past decade, it has overcome its high valuation and returned more than 1000% for its long-term investors.

Foolish Summary

The price to earnings ratio has its advantage when it comes to valuing a company. Nonetheless, investors need to be aware of the pitfalls of using this ratio blindly. Other methods of valuation investors might be interested in using are the price to book (P/B) ratio, the Discounted Cash Flow (DCF) model, and the price to sales (P/S) ratio, among others.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim doesn’t own shares in any companies mentioned.