The P/E Ratio Can Be Overstated or Understated Depending Upon Accounting Issues and Temporary One-Time Gains or Losses

It isnt enough to pull up a stock quote and check the p/e ratio of a stock.  Last night, I was sitting in bed, reading through the transcript of The Coca-Cola Company conference call and watching interviews about various political issues.  I thought it might be a great time to explain what I mean so I scratched out some notes to write you about the p/e ratio and the inverse, the earnings yield, when it comes to investing and, specifically, value investing.

Using Coca-Cola As an Example of the P/E Ratio

First, if you pull a stock quote for Coke, it looks like the p/e ratio is 13.44, which is an earnings yield of 7.44%.  However, if you delve into the figures, you see that in 2008, Coke reported $5.807 billion in net income, in 2009, Coke reported $6.824 billion in net income, and in 2010, Coke reported $11.809 billion in net income.

That looks like a big jump between 2009 and 2010, going from net income of $6.824 billion to $11.809 billion, an increase of $4.985 billion or 73%.  You need to understand what caused that reported increase in profit to understand whether the price Coke shares trade for in the market is rational or not.

When you look into the financials, at first glance it looks like Coke reported a $5 billion non-tax accounting gain as part of the revaluation of the shares it held in a separate company, Coca-Cola Enterprises (CCE), the largest Coke bottling system in the world.  This was probably caused after Coke acquired the North American operations of CCE but Ill have to actually pull the SEC filings myself and read them.  If that turns out to be the case, the company wouldnt have any more cash lying around headquarters, no taxes would have been paid on that $5 billion, and it was nearly a requirement under GAAP to try to get the books closer to economic reality as the result of a significant acquisition.  It also looks like there were additional gains in there, such as $200 million for a comparable structural item.

Focus On Long-Term Earning Power from Continuing Operations When Thinking About the P/E Ratio

Going forward, those profits wont exist.  They were accounting entries that were necessary and desirable.  But they arent indicative of higher earning power going forward, in my opinion.  It isnt going to be there next year or the year after that.

The opposite is also true sometimes you will find a company that appears to be trading at an astronomically high p/e ratio when the stock is actually cheap.

Realize, I am not in any way, shape, or form telling you whether I think Coke is a great bargain, expensive, or fairly priced at these levels.  Its not my job to do your thinking for you.  I am using this well-known company as a case study to show you how the real p/e ratio in terms of regular earning power from continuing operations being different from the sticker p/e that makes it into newspapers and online financial sites.