Arguably the simplest of all the equity valuation methodologies, the P/E ratio is also a metric with a large number of shortcomings. In the basic sense, the P/E ratio is attractive to investors because it is easy to apply (no detailed cash flow forecasts or estimates of the cost of capital are required) and is logical (ie. the more [recurring] earnings I can purchase for each dollar of my investment, the greater the value I am receiving).

The justified P/E ratio tells us what a fair multiple of earnings we should pay for a company with a given set of characteristics. This can be given as follows:

Justified P/E = Dividend Payout Ratio / (Cost of Equity – Growth in Earnings)

This tells us that investors should be willing to pay higher P/E ratios for companies with: higher dividend pay-out ratios; lower cost of equity; and higher projected earnings growth. However, while the first of these factors is easily observable, the latter two are complex concepts that vary with time and are very difficult to estimate. In addition, the output multiple is very sensitive to small changes in the estimates of the cost of equity and the earnings growth rate. Because of this, companies with similar P/E ratios could be very different value propositions depending upon the individual circumstances of the businesses in question, and I do not believe it is possible to encapsulate these issues into the Justified P/E equation given above.

These shortcomings in my opinion severely limit the use of the P/E Ratio to initial stock screens, rather than as a key part of the company valuation and investment decision-making process. The major limitations are as follows:

1. The ratio takes no account of the companys ability to convert earnings into cash flow unless those earnings are paid-out in dividends. For example, assume two companies both trade at the same P/E ratio, one is a manufacturing company with heavy capex needs, the other is a software company which expenses all its development costs (consequently the software firm has much superior cash conversion). The P/E ratio is telling us that these companies are valued the same, but all else being equal, it makes sense to pay more the the software company (relative to its profits) as it is generating more cash for each dollar of earnings. Therefore the P/E ratio is unhelpful unless cash generation is also considered.
2. The ratio takes little account of the companys capital structure. Although one of the determinants of the P/E ratio is the companys cost of capital, this is challenging to estimate and the P/E ratio is highly sensitive to changes in this assumption. Because financial indebtedness, operating leases, pension fund deficits and open derivative positions all increase the potential volatility of future earnings – and the probability of bankruptcy occurring – companies with greater levels of indebtedness should have a lower P/E ratio than their more-conservatively-financed counterparts.
3. The denominator of the ratio can easily be manipulated. Although in the long-term there must be some level of convergence between earnings, in the short-term company management has significant flexibility to manipulate the earnings figure. This can be done by setting accounting policies for revenue recognition, depreciation and capitalising costs, and also by writing-down or revaluing assets on the balance sheet. This means that earnings can differ significantly from the economic profit of the company.
4. The ratio is difficult to apply to cyclical stocks. Because cyclical companies experience profitability that rises and falls with the economic cycle, the denominator of the P/E ratio changes regularly. This can mean that the P/E ratio can sometimes peak near the bottom of the earnings cycle (and near the share price trough), which may also be the best time to purchase the stock. Therefore for cyclical companies it may be advantageous to look at average earnings over a longer period, or estimate what mid-cycle earnings would be, and to use this to calculate the P/E ratio.
5. The P/E ratio is a relative measure, and therefore does not inform the user what share price should be paid for a stock. The P/E ratio is, at best, only useful in comparing companies in similar industries (see point 1) and with similar capital structures (see point 2), but while it may offer an insight into relative valuation between the companies in question, it is of little use in determining what actual price should be paid for a share in a company. For this to be done, the analyst should make use of absolute valuation methodologies such as discount cash flow or economic value added.

Because of these factors, Cautious Bull would strongly advise readers not to rely on on P/E ratios when making investment decisions without also considering cash conversion, leverage, quality of earnings, and the stage of the economic cycle.