Analyzing the "E" in P/E Ratios

Price/earnings ratios have long been a favorite market metric for investors. The common belief is that a low P/E suggests that a stock is undervalued and that a high P/E means that the price may be too high. That’s not always the case, say investment experts.

A high P/E may indicate that the stock is poised for a good run-up, while a low P/E may signal that a company is having problems. The biggest problem with using P/E ratios to gauge a stock’s value, however, is figuring out how much trust you can put in the “E” part of the ratio.

Earnings come in two flavors: forward earnings, based on analysts’ expectations over the next 12 months; and trailing earnings, which reflect the actual earnings for the past 12 months. Both of these approaches have significant downsides. Forward earnings may be based on projections that are wrong—often spectacularly so. Until a year ago, P/E ratios based on forward earnings of banks and other financial companies assumed that their outsize profits, which were actually based on shaky mortgage securities, would continue. Market observers also caution that the current 12.2 forward-earnings P/E for the S&P 500, while low by historical standards, assumes a big turnaround in profits over the next year. Trailing earnings have the disadvantage of looking in the rearview mirror while the stock market is focusing on the road ahead. An investor using trailing earnings as a guide could easily miss significant future trends that could send a stock higher.

Due diligence is the answer, say many market experts. P/E ratios can be a useful starting point in your research, but you need to go deeper into a company’s balance sheet before you put any money up.