Why investors should not use P/E ratio as a valuation tool

MANILA, Philippines  —Investors often rely on the price-to-earnings (P/E) ratio as a measure of stock valuation. It is often used to determine whether a stock is cheap or expensive based on its relative ratio to other stocks or the market average.

However, it is important to understand that relying on P/E ratios has several limitations that we need to consider. One constraint of the P/E ratio is that it primarily focuses on the current earnings of a company relative to its share price, thereby overlooking its future growth prospects.

For example, Jollibee’s P/E ratio of 40.6 times may suggest that it is overvalued because it is three times higher than the average market P/E of 12.5 times. But such a high P/E ratio may also indicate investors’ confidence in the company’s potential for significant future earnings.

Conversely, a low P/E ratio does not necessarily mean a stock is undervalued. If company earnings have been declining and the market perceives it to have no growth potential, the resulting decline in the stock price will lead to a low P/E ratio.

The reliance of P/E ratios on reported earnings can make them susceptible to accounting manipulation. Companies can employ various techniques to artificially boost their earnings, including accelerating revenue recognition, increasing cost deferrals, raising accruals and reducing depreciation expenses, all of which can distort the P/E ratio.

According to the Beneish M-Score, a quantitative scoring model used to determine the likelihood of accounting manipulation, about 25.4 percent of listed companies listed on the Philippine Stock Exchange are considered to be engaging in earnings manipulation.

Comparing P/E ratios across industries can be misleading since what may be considered a high P/E ratio in one industry could be normal in another.

Different industries exhibit varying growth rates and risk profiles, which lead to differences in P/E ratios. For instance, currently, average property sector P/E ratio is about 6.1, while it’s higher at 14.6 for the food and beverage sector.

If you only consider the P/E ratio, property stocks may appear attractive. However, because high interest rates make people less interested in buying properties, investing in property stocks becomes riskier.

As a result, investors demand higher returns to compensate for the additional risks, resulting in the lower P/E ratio.

P/E ratios also fail to account for capital structure. The level of leverage a company employs to finance its growth and the associated risks are not reflected in P/E ratios.

For example, Wilcon and PLDT have similar P/E ratios at 26 times, but they belong to two different industries and have different risk profiles. PLDT has a debt-to-equity ratio of 2.3 times, while Wilcon has only 0.8 times.

The focus of P/E ratio on earnings does not take into account other factors that can influence the value of a company. Factors such as balance sheet strength, management quality, competitive position and potential industry disruptors are essential for a comprehensive assessment of value.

Because of its inherent limitations in assessing the true value of a stock, the P/E ratio should be used more as a pricing indicator rather than a valuation tool. As a pricing indicator, the P/E ratio can be used to provide insights into the market sentiment.

Investors can better understand how the market perceives a stock at a given point in time. A high P/E ratio may indicate that investors are optimistic about the future earnings growth that leads to a premium valuation. Conversely, a low P/E ratio may suggest undervaluation or pessimism about company prospects.

The P/E ratio can also be used as a pricing reference of a stock. For example, before the pandemic, the average P/E ratio of Puregold in 2019 was 16.9 times and its net income was about P6.7 billion.

Today, the 12-month trailing net income of Puregold stands at P9.4 billion and yet its P/E ratio is only 8.6 times. By reference, we can price Puregold at its 2019 P/E ratio of 16.9 times as target, which is almost double its current share price.

But we can also argue that because of the higher risk environment, we can price Puregold at a lower P/E ratio from its reference. Let’s say, instead of 16.9 times, we can consider only 70 percent or 11.8 times as target P/E.

While the P/E ratio serves as a common tool for stock valuation, its reliance comes with notable limitations. Hence, it is prudent to view the P/E ratio more as a pricing indicator than a definitive valuation tool. By understanding its role in gauging market sentiment and providing valuable insights, investors can make more informed decisions. INQ

Henry Ong is a registered financial planner of RFP Philippines. Stock data and tools were provided by First Metro Securities. To learn more about investment planning, attend the 106th RFP program this March 2024. To register, email [email protected] or text 0917-6248110.