One of the most common metrics used to gauge a stock's value is its price-to-earnings (P/E) ratio. It's the multiple of earnings you're willing to pay for a business -- the current price divided by the company's earnings per share. It's a good way to get a rough idea of whether a stock is cheap or expensive, but Fools shouldn't rely entirely on the P/E for their value assessments.
How the P/E works
For a different perspective, try flipping the P/E ratio to an E/P ratio, commonly referred to as the earnings yield. Like a yield on a bond, this number shows a company's annual earnings as a proportion of its market value. Buying one share of Amazon at $77, with EPS of $1.56, equates to an earnings yield of approximately 2% ($1.56 divided by $77). For Best Buy, the earnings yield is 6.8%, because each share of Best Buy stock, currently trading around $35, is expected to generate $2.39 in earnings per share. In the long run, Best Buy investors theoretically should earn a better rate of return than Amazon investors for each dollar invested.
Yet over the past three years, Best Buy has seen its stock lose an average of 11% annually, while Amazon's stock has jumped 29% per year. Of course, this is a very extreme, and to some degree unfair, comparison, since the two companies have very different business models. It's an apples-to-oranges comparison between an online retailer versus a big-box store. Like Amazon, Best Buy's stock-price performance was downright astonishing during its early years. So, what gives?
Avoid the pitfalls
Does the difference in P/E ratios alone make one company a better investment than the other? Not really. Although useful, P/E ratios have limitations. Yet investors tend to rely excessively on this one variable in determining an investment's attractiveness.
Most investors tend to agree that in general, businesses with lower P/E ratios tend to outperform high-P/E-ratio companies in the long run. However, that premise alone does not imply that all companies sporting single-digit ratios are superior investments. Just look at Citigroup
Quality, not quantity
Fundamental problems exist with the P/E ratio. First, the "P" only refers to the equity price of a business; it doesn't consider debt. That's fine for companies without debt, like Apple
The "E," or the per-share net income of a company, also poses problems. Creative accounting decisions, such as changing depreciation schedules or including non-recurring gains at certain points in time, can manipulate this figure. We all know that management has a considerable incentive to meet earnings expectations, so you should always examine earnings with a healthy dose of skepticism.
Most investors employ a host of investment considerations when assessing the value of a business. While the P/E ratio is a very useful resource, its often-ignored limitations can sometimes catch smart investors off guard. Use it carefully and prudently, and you'll be a lot less likely to fall into costly situations.
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This article, written by Sham Gad, was originally published on Dec. 5, 2007. It has been updated by Dan Caplinger, who doesn't own shares of the companies mentioned. Apple, Amazon.com, and Best Buy are Motley Fool Stock Advisor picks. The Fool owns shares of Best Buy, which is also a Motley Fool Inside Value selection. Try any of our Foolish newsletters today, free for 30 days. The Fool has a priceless disclosure policy.