False Signal of PV Ratio
False Signal of PV Ratio
False Signal of PV Ratio
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Located right in the company's latest published 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. It's the company's future earnings that investors are interested in most since as they reflect a stock's future prospects. Forward earnings (also called future earnings) are based on the opinions of Wall Street analysts. Analysts, if anything, typically tend to be over-optimistic 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 overvalued. A P/E ratio, even one calculated using a forward 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 PEG ratio: PEG = PE/forecast EPS growth rate over the next twelve months In a nutshell, the lower the PEG ratio, the better. A PEG of one suggests that the P/E is in line with growth; below one implies that you are buying EPS growth for relatively little; a PEG greater than one 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. (Learn how this simple calculation can help you determine a stock's earnings potential. Read 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 balance sheet. Debt levels have an impact on 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 enterprise value or EV in place of its Price or P. (simplified) EV = Market Capitalization + Net Debt 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 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 EBITDA in the denominator. (This measure has its benefits, but it can also present earnings through rose-colored glasses. Check out A Clear Look At EBITDA.) 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 carefully. No single ratio can tell you all you need to know about a stock. Be sure to use a variety of ratios to get a fuller picture of financial performance and stock valuation.
by Ben McClure (Contact Author | Biography) Ben McClure is a long-time contributor to Investopedia.com.
Ben is the director of Bay of Thermi Limited, an independent research and consulting firm that specializes in preparing early stage ventures for new investment and the marketplace. He works with a wide range of clients in the North America, Europe and Latin America. Ben was a highly-rated European equities analyst at London-based Old Mutual Securities, and led new venture development at a major technology commercialization consulting group in Canada. He started his career as writer/analyst at the Economist Group. Mr. McClure graduated from the University of Alberta's School of Business with an MBA. Ben's hard and fast investing philosophy is that the herd is always wrong, but heck, if it pays, there's nothing wrong with being a sheep. He lives in Thessaloniki, Greece. You can learn more about Bay of Thermi Limited at www.bayofthermi.com. ** This article and more are available at Investopedia.com - Your Source for Investing Education **