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Its pleasing simplicity and ease of application make the price to earnings (P/E) ratio one of the most commonly used valuation metrics in the world. Almost every financial website, from Bloomberg Bloomberg to Google Google Finance, puts the P/E near the top of the page, right near the stock price and market cap. Investors constantly reference the P/E ratio when making a bullish or bearish case for a stock.

However, the vast majority of evidence suggests that P/E ratios are an unreliable way to measure the true value of stocks. There are several reasons for this misconception, including the following:

The earnings denominator of the P/E ratio is subject to accounting rules that are constantly being reshaped. Former Financial Accounting Standards Board (FASB) chairman Bob Herz expressed this sentiment when we spoke to him last year, saying:

“I’m not a big fan of earnings multiples, of P/E multiples and things like that. We have made over time dramatic changes in the accounting that affect the denominator of the P/E ratio, but it’s not clear whether and how that flows through the valuations.”

The changing treatment of employee stock options is an example of how accounting rule changes affect reported earnings and make P/E’s between different stocks incomparable. One of the biggest in recent history was the 2006 FASB decision to require companies to report the cost of stock options on their income statements. This change officially went into effect in 2006. Unofficially, many companies reported stock option expense years in advance of the ruling.

For instance, Microsoft Microsoft (MSFT) began expensing stock-based compensation in 2004. This expense lowered MSFT’s reported earnings decline by $1.8 billion in 2004 and made MSFT’s P/E incomparable to all other stocks that were not reporting their stock option expense.

Because companies have different fiscal year ends, the date they are required to follow new accounting rules is different too. So, at any given time, the EPS of some companies reflect the rule change while many others do not.

Accounting Earnings Are Often Misleading

Accounting earnings are based on rules designed for debt investors, not equity investors. They contain numerous loopholes that allow companies to inflate earnings. It takes diligent research in the financial footnotes in order to convert reported earnings to economic earnings .

AT&T AT&T (T) is one example of a stock with a P/E that is based on artificially inflated accounting earnings. T earned nearly $8 billion in non-operating income from its pension plan assets in 2013. This non-operating income allowed T to more than double its reported earnings in 2013. T’s artificially high earnings gave it a low P/E of 10.

In reality, T’s NOPAT actually declined by 5%. While the stock isn’t hugely expensive, it does have roughly 30% profit growth priced into its valuation. Investors who just look at the P/E get a misleading view of the stock’s valuation.

P/E Overlooks Key Liabilities And Assets

A stock’s worth is based on the present value of future cash flows attributable to the shareholder. Accounting earnings do a poor job of measuring cash flows, as we’ve already established. However, the other big flaw with P/E ratios is that they don’t account for many of the more senior claims on cash flows.

T exemplifies this issue as well as it has nearly $35 billion in deferred tax liabilities .

Olin Corporation (OLN) also exemplifies this issue. OLN looks cheap with a P/E of 13. However, it has off balance sheet debt, pension, and other liabilities that add up to

$500 million (25% of market cap). With a discounted cash flow model, we can see that its current valuation of

$27/share implies that OLN will grow NOPAT by 5.5% compounded annually for 35 years. Only with a real grasp on the true cash flows of the business can one get an accurate measure of the future cash flow growth implied by the stock’s valuation.