# Adjustments To Net Income In Calculating Operating Cash Flows Include: 5 Common Misuse of P/E Ratio

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## 5 Common Misuse of P/E Ratio

The price-to-earnings (P/E) ratio is the most widely used ratio in investing. A Google search for the term ‘P/E ratio’ will yield 2.3 million results. Very simply, the P/E ratio is the ratio of a stock’s price divided by its earnings per share (EPS). If Company A trades at \$10 per share and earns \$2.00 per share, then A has a P/E ratio of 5. This means that it takes 5 years for the company’s earnings to pay off your initial investment. If you reverse the P/E ratio, we get the E/P ratio, which is the return on our investment. In this case, a P/E of 5 equals a yield of 20%.

The P/E ratio is convenient and very easy to use. But that’s why so many investors abuse it. Here are some common misuses of the P/E ratio:

Using the trailing P/E. Trailing P/E is the company’s price-to-earnings ratio for the last 12 months. For cyclical companies coming off peak earnings, the P/E ratio is misleading. The trailing P/E ratio may look low, but its forward P/E may not. Forward P/E is calculated using a company’s projected earnings per share. Forward P/E is more important than trailing P/E. After all, it is the future that counts.

Ignoring earnings growth. A low P/E ratio does not necessarily mean that a stock is undervalued. Investors should consider the company’s growth rate. Company A with a P/E ratio of 15 and 0% earnings growth may not look as attractive as Company B with a P/E ratio of 20 and 25% earnings growth. The reason is that if both share prices remain the same, after 3 years, Company B’s P/E ratio will decrease to 10.3 while A will still have a P/E ratio of 15. The lesson of the story is not to use P Sam /E ratio for asset valuation.

Ignoring a one-time event. The P/E ratio always includes a one-time event such as a restructuring charge or a downward adjustment of goodwill. When this happens, the ‘E’ in the P/E ratio will appear low. As a result, this event increases the P/E ratio. Investors will do well to ignore this one-time event and look beyond the high P/E ratio.

Ignoring the balance sheet. That’s right. Investors often ignore cash and long-term debt embedded on the balance sheet when calculating the P/E ratio. It is true that companies with higher net cash on the balance sheet tend to get a higher P/E valuation.

Ignoring the interest rate. Using only the P/E ratio for our investment decision will have disastrous results. As explained earlier, when we invert the P/E ratio, we get the E/P ratio. The E/P ratio is essentially the return on our investment. A stock with a P/E of 10 yields 10%. Stocks with a P/E of 20 yield 5% and so on. If the interest rate rises to 6%, then stocks trading at a P/E of 20 will become overvalued, all else being equal.

As with other financial ratios, the P/E ratio cannot be used only to value a company. The interest rate fluctuates, earnings per share rise and fall, as does the share price. All this should be taken into account when choosing a potential investment.

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