The Real Problem with P/E Ratios

The simple P/E ratio is still being widely used as a proxy for how cheap/expensive a stock is. So what P/E ratio should you use to value your stock? 10? 20? 50? What is the logical basis behind the P/E ratio? Why 10, 20 or 50?

That's a major concern that needs to be answered. Consider Wal-Mart (WMT). If you take an average of WMT's P/E ratio over the past few years, you can probably get a number around 30. So now that its P/E ratio is 18, is it considered cheap? Should you project future earnings and multiply that by 30 to get WMT's price?

And what if I tell you that WMT's yearly average P/E ratio has been consistently declining over the past few years (see the 10-year summary on MSN Money)? Has something changed?

The answer to all these questions lie in the simple concept — intrinsic value aka fair value.

How much you should pay for a company depends on what the company is worth (sounds like a tautology). And what the company is worth now, is the present value of the future worth of the company. The fair P/E ratio is simply a result you get when you divide the fair value by the earnings, it is NOT something that you use in a fundamental manner to value a company.

This also explains the reason why, you can buy a company at a certain price, and even though year-after-year, sales increases, earnings increases, equity increases, but the share price may keep on dropping (with a decreasing P/E). More often that not, it is a case of overpaying for the company right at the start, without a strong basis in determining its intrinsic value.


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