The PE ratio is one of the most popular metrics for investors.
It evaluates how much you are paying for a company for every dollar that the company earns. It is possible to use the stock’s PE ratio to evaluate companies. It is one of the main tools in every investor’s arsenal.
However, we must be careful when to and when not to use it. Like a double edged sword, the PE ratio can help us profit from the markets. At the same time, it can also lead to inaccurate valuations and cause us to lose money.
Therefore, we need to be careful with using this metric.
These are some of the considerations before using PE ratio as a metric when buying stocks.
1) PE Ratio Works In Low Interest Rate Environments
Low interest rates would mean that the quality of a company’s earnings are high. If interest rates remain at 1%, it would mean that a $1 curry puff would cost $1.01. Hence there will not be much fluctuations in Old Chang Kee’s revenue.
However, if inflation were to increase to 4%, it would mean paying $1.04 for every curry puff.
This affects the quality of earnings because even though the company has earnings, the majority of it would be due to the rising interest rates, and not because they sold more items.
Investors buying in these companies may make the mistake of assuming that Old Chang Kee has high earnings, when in fact most of its earnings is due to an inflated interest rate, causing them to miscalculate and lead to losses.
2) PE Ratios Differ Across Industries
Think about a company like Old Chang Kee. It sells curry puffs day in and day out.
Notice how its earnings are fairly consistent throughout the year because we know that there will be people every day queuing up at the Old Chang Kee store to grab their curry puffs.
Hence, for such companies, using the PE ratio as a tool for valuation can be useful because of their consistent earnings.
On the other end of the spectrum, we have huge companies that have large projects which can last for several years. A good example would be Keppel. They build oil rigs and sell them to oil companies.
Only when these oil companies are profitable or have found new oil drilling spots, will they be more inclined to purchase more oil rigs from Keppel. One oil rig could take several years to build.
You cannot compare Old Chang Kee’s PE ratio with that of Keppel because they are in very different industries.
For instance, if Old Chang Kee has a PE ratio of 20, and we apply this PE ratio of 20 to Keppel, investors would lose money because the PE ratio across industries differ. One is in the food industry and the other is in the rig building industry.
3) PE Ratio Does Not Give You The Full Picture
Investors usually get this wrong because they assume that a stock is cheap when they see a low PE ratio. Many investors buy stocks that have low PE ratios because they think that it is cheap.
However, this is inaccurate and may not be the case, especially with cyclical companies such as Keppel. Keppels earnings fluctuate every year.
For instance, as what I have mentioned above, Keppel may have major rig building projects last year, making their earning figures high.
This year, they do not have any projects at all.
Hence, earnings for this year would be very low. It is a case of stocks appearing cheap at the point when they are most expensive, and appearing expensive at precisely the moments when they are the cheapest.
Using PE ratio to valuate these companies would not be accurate because in certain years, PE ratio will be high, in other years, low.
Thus, buying a stock such as Keppel at the point when PE ratio is low will make an investor lose money because it is also the point which Keppel Stock is most expensive.
Note: I do not own shares in any of the above companies.