Intro to Fundamental Analysis: What's Wrong With the P/E Ratio?

Far too often, the relative attractiveness of a stock is discussed in terms of its price-to-earnings ratio (P/E Ratio). This is an inherently flawed method for determining a stocks value; although the "P" portion of the equation is an objective fact at any given point in time, the "E" is exceedingly more suspect in nature. For those new to this, "P" is the price of the stock, and "E" represents earnings, or net income. To keep things simple, suppose you have a $10 stock, issued by Company X. Let's also say that Company X has earned 25 cents/share each quarter of the past year, and it projects earnings of 25 cents/share for each of the next four quarters. In this situation, Company X will earn $1/share this year. Therefore, at a share price of $10, the stock is trading at 10 times earnings, or a P/E Ratio of 10. Note: Some investors like to use a forward P/E ratio, which basically looks at the next four quarter's worth of estimated earnings to determine the "E". Other fans of the P/E use trailing earnings to calculate the denominator; in other words, the sum of the four most recently reported quarterly per share earnings. I purposefully fashioned my hypothetical Company X earnings report such that both the forward and trailing P/E ratios are 10. This doesn't happen in real life.

Now that everyone is hopefully up to speed, I can get into the real issue here: What's wrong with the P/E ratio? Well, as I said before, the problem is with the "E" or net income. In small business, net income - or more commonly "profit" - is simply the cash left over after you pay the bills. It gets a little more complicated with publicly traded corporations, all of which must adhere to Generally Accepted Accounting Principles (GAAP). Under GAAP, the quarterly income statements that all corporations must file include, and in some cases are dominated by, non-cash items. Let's say a company purchases a tractor for $10,000. Fast forward one year, and the company has accumulated say $900 worth of depreciation on the tractor. That $900 will be recorded as an expense on the income statement, reducing reported earnings despite there never being a $900 change in the company's cash position. As a contrasting example, consider a company that extends credit to a large customer on December 20th, selling $1M worth of software. The seller's assets will increase by $1M via a debit to accounts receivable, and revenue will increase by $1M. Assume that the terms of the sale on account dictate payment within 30 days. For the year ended December 31st, that company will report the $1M as revenue, although they probably won't have received the cash yet.

A further earnings distortion occurs based upon the quarterly price fluctuations of balance sheet assets the company lists as "marketable securities". Often times, a company will use surplus cash to invest in other company's stocks. The change in market value of these securities, whether or not they are actually sold for a profit (or loss), will be recorded as income (or loss) on the quarterly income statement. Obviously, these items are neither indicative of the company's operating performance, nor indicative of changes in its cash position.

Hopefully, by now all readers are appreciative of the reality that a corporation's reported net income is a fickle beast, and that it should not be trusted. Therefore, any ratio whose entire denominator consists only of "net income" should be viewed through a skeptical lens. Don't worry though, as this post is only the first part of the Fundamental Analysis series. Future posts will help investors develop a more holistic and accurate approach to stock analysis and valuation.

Next up in the series: Cash Flow From Operating Activities (CFFO) to Net Income Ratio Sphere: Related Content