The P/E ratio also has some important drawbacks. A P/E ratio of 15 does not mean a whole lot by itself; it is neither good nor bad in a vacuum. As we discussed previously, the P/E ratio only becomes meaningful with context.
However, keep in mind that using P/E ratios only on a relative basis means that your analysis can be skewed by the benchmark you are using. After all, there will be periods when entire industries will become overvalued. In 2000, an Internet stock with a P/E of 75 might have looked cheap when the rest of its peers had an average P/E of 200. In hindsight, neither the price of the stock nor the benchmark made sense. Just remember that being less expensive than a benchmark does not mean something is cheap, because the benchmark itself may be vastly overpriced.
When you're looking at a P/E ratio, also make sure that the "E" part of the equation makes sense and is representative of a company's ongoing profits. A few things can distort the P/E ratio. First, firms that have recently sold off a business can have an artificially inflated "E" and a lower P/E as a result. A company may book a big one-time gain from the sale of a division, boosting reported earnings, but based on operating earnings, the stock may not be cheap at all.
Second, reported earnings can sometimes be inflated (or depressed) by one-time accounting gains (or charges). As a result, the P/E ratio can be misleadingly high or low. For example, a firm's earnings can be depressed due to a one-time charge for litigation or other extraordinary events. This may in turn give the stock what appears to be a sky-high trailing P/E.
Third, cyclical firms that go through boom and bust cycles--semiconductor companies and auto manufacturers are good examples--require a bit more investigation. Although you would typically think of a firm with a very low trailing P/E as cheap, this is precisely the wrong time to buy a cyclical firm because it means earnings have been very high in the recent past, which in turn means they are likely to fall off soon. Likewise, a cyclical stock is going to look the most expensive when its "E" has bottomed and is about to start growing again.
Lastly, there are two kinds of P/Es--a trailing P/E, which uses the past four quarters' worth of earnings to calculate the ratio, and forward P/E, which uses analysts' estimates of the next four quarters' earnings to calculate the ratio. Because most companies are increasing earnings from year to year, the forward P/E is almost always lower than the trailing P/E, sometimes markedly for firms that are increasing earnings at a very rapid clip. Unfortunately, estimates of future earnings by Wall Street analysts--the consensus numbers you often read about--are consistently too optimistic. As a result, buying a stock because its forward P/E is low means counting on that future "E" to materialize in its entirety--and that usually doesn't happen.
Price/Earnings Growth (PEG) >>