Why Investors Can't Just Trust P/E Ratios

Andrey Dashkov |

flaws of p/e ratio, how to use p/e ratio, p/e ratio of stock, how to value a stock, other metrics besides p/e ratio

College reunions are toxic. Except for the few precious moments of genuine human connection, these parties are nothing but status pageants. Suits and watches are inconspicuously glanced at, vacation photos (carefully selected the night before) are passed around; compensations guesstimated; Platinum Master Cards flashed (“Oh no, let me take care of this round!”); spouses evaluated based on trophy-worthy qualities… and inconspicuously glanced at.

It’s hard to tell true, praiseworthy success from carefully crafted smoke and mirrors. Your college friend may have rented that car, watch, suit—and even his “spouse.” In fact, there are escort agencies out there that provide “dates” for single men to social occasions. Don’t ask me how I learned about it.

The point is, both people and companies like to project high status and success to the public. Not only do your friends from Beta Phi Delta want to look alpha (pun intended), but companies, too, often want you to think they earn more than they actually do.

There are many incentives to do that: management’s compensation may be tied to earnings-per-share (EPS) goals; the company may be trying to maintain an image of rapid growth; or it could be attempting to raise funds by issuing debt or shares. Higher EPS would benefit the company and the team at the helm in all of these cases.

The Illusory P/E Ratio

Another reason why companies try to massage their earnings is that millions of investors pay attention to the price-to-earnings ratio (P/E). It is one of the most intuitive financial metrics. Potential investors see it all across the Internet, on free finance sites and many trading platforms. However, despite its popularity, I’d argue that it’s one of the most illusory financial metrics that exists, and the blame is on the denominator, earnings. Let’s see how we can make better use of it.

“E” in the P/E ratio stands for earnings per share, which is a ratio itself. EPS is the company’s net income for the reported 12-month period (or forecasted net income for the next 12 months) divided by its shares outstanding. Without going into too much detail, here are some of the potential issues with the usefulness of reported historical, or trailing, earnings per share for investors:

  • Seasonality. Earnings of a lot of companies fluctuate due to seasonal buying activity, weather, and other factors. In these cases, quarter-to-quarter comparisons are meaningless, and it’s necessary to understand the company’s operating cycles (annual, based on contract renewals, etc.) to make use of the reported earnings.
  • Dilution. There are two broad measures of shares outstanding: basic (or common) and diluted. Diluted shares outstanding include common shares, options, warrants, convertible preferred shares, and convertible debt. All of these can potentially be converted to common stock and result in lower earnings per share because of the higher denominator in the EPS ratio. However, when you look at a P/E ratio on the Internet, it’s not always clear whether it was based on basic or diluted shares. The latter is more conservative, and we pay more attention to it than to the basic EPS.
  • Accruals-based accounting, in which revenues are recognized at the moment they’re earned, and expenses are recognized when they’re incurred. In contrast, under cash-based accounting, revenues are recognized when cash is collected, and expenses are recognized when cash is paid.

    Accruals-based accounting has its advantages:
    • It allows the company to match revenues to expenses in time more closely (for example, the cost of a piece of equipment is depreciated over its useful life to match the revenues this equipment generates); and
    • It provides the market with information about the company’s operations as soon as it has enough objective evidence that the transaction will be fulfilled. For example, when a company sends an invoice to a customer, it records a receivable, which sends a signal to the market that a sale took place. We don’t need to wait until the actual funds are deposited in the company’s bank account, which may take a month or more, to become aware of this sale.
    However, accrual accounting has two major drawbacks for analysts and investors:
    • Reported income and expenses do not mirror actual cash inflows and outflows; and
    • Management can accelerate or postpone recognition of revenue and expenses, which makes reported net income figures less reliable.

    Consider a real-world example. A friend of mine—let’s call him Steven—spent several years as a credit manager. One of his responsibilities was to expense a “reserve” for anticipated credit losses. The first time he was about to charge the expenses, he estimated them realistically and quickly realized that it wouldn’t work. The reserve wasn’t there to cover the related losses calculated fairly and correctly.

    After a discussion with the corporate accounting department (his superior), if they needed to find more profit to make their numbers, Steven would lower his reserve estimates. If they were having a good year, he was told to increase the reserve write-off to provide a cushion for the next quarter.

    The beauty of it was that such draws and deposits are almost impossible to catch unless the amounts are outrageous, so any auditor would overlook them. Steven and his team were safe legally, but the practice misrepresented his company’s financial performance nevertheless.

    When I asked another friend—let’s call him Jack—to share any stories about his company’s creative accounting, he said he too would get calls from the corporate accounting department at the end of each quarter. Another easy target to massage is insurance costs. To get the lowest prices, many of its insurance policies were paid annually, and the premium period did not correspond with the accounting year. If the company was having a good quarter or year, he was encouraged to write off the entire annual premium in that accounting period. Conversely, if it was struggling to make its numbers, the team would show the premiums for future months as “prepaid insurance,” effectively delaying the expense until the next accounting period.

    The effect, as with our first example, was to smooth out period-to-period fluctuations to keep stockholders happy by “making their numbers” or beating them by a little bit. The justification was that they weren’t really manipulating profits—“in the long run, it all comes out in the wash.”

    Part of Jack’s annual performance review was “being a good team player.” Helping the corporate team was part of that evaluation.

    Other common revenue and expense “management” techniques include adjustments to how depreciation expense is calculated, which is doable within limits under generally accepted accounting principles (GAAP), and can affect net income as desired; and adjustments to revenue recognition policies that technically comply with GAAP but distort the underlying economic reality to artificially boost the top line and thereby juice earnings.

Normalization Helps Solve the Numbers Game

The first two issues with earnings—seasonality and dilution—can be addressed simply: instead of looking at price to reported earnings per share, pay attention to P/E calculated from normalized earnings based on diluted shares outstanding. Normalization takes care of seasonality and some of the nonrecurring revenue and cost items. Using diluted share count instead of basic will return a more conservative number, because it assumes that all options, warrants, and convertible debt are converted into common shares. The more common shares there are, the lower the EPS.

As shareholders, we need those conservative estimates. Our returns (share price appreciation and dividend income) aren’t based on management achieving arbitrary earnings targets that can be fiddled with, but on how the company functions as a business. To get a clearer picture, using normalized diluted EPS should help.

Note that I wrote “clearer” but not “clear,” “true,” or “objective.” The reason we stay away from such absolutes is that it’s prohibitively difficult to say what’s going on with any company’s earnings with 100% accuracy.

One simple tip can help you make better use of P/E: use normalized earnings and diluted shares. These numbers are often available on free websites or in SEC filings.

Now I’ll go ahead and clear my browser history. Although reading about escort services for college reunions is a great study of the human condition, I’ll have a hard time explaining to my lovely wife why I need to do it for work. And speaking of the work I do… you can receive more unique insights on better investing strategies by signing up for our free, retirement-focused e-letter, Miller’s Money Weekly.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer


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