The PE ratio has its flaws… To value a company, use this ratio instead

Julie Brownlee, Fsp Invest, 23 Feb. 2015

Tags: pe ratio, disadvantages of pe ratio, financial ratios, cape, pe, valuing a company, how to value a company,

The price earnings (PE) ratio is one of the most widely used financial ratios in the investment world.

Yet in spite of its popularity, the PE ratio has its flaws. One major flaw is that it can lead investors to jump to the wrong conclusion about the profitability of a company.

So what other financial ratio should you use instead?

Read on to find out…

What is the PE ratio?

You can use the PE ratio to value a company or a market.

To calculate the PE ratio, you take the current share price and divide that by the current (or forecast) earnings per share (EPS).

Broadly speaking, the lower the PE is, the cheaper the share or market.

The problem with the PE ratio

The major issue with the PE ratio is that a company’s current levels of earnings (profits) may not reflect what the company can make every year.

For instance, earnings of certain types of companies are cyclical. This means they follow the economy’s fate up and down.

So a PE ratio can be misleading if you use the wrong level of earnings to calculate it.

Take a construction company. The construction sector is cyclical. A company’s shares in the sector may look cheap based on its PE ratio during a construction boom. But if a recession comes along the next year, its profits will take a heavy tumble. So its shares are clearly not cheap.

How to get over the PE ratio’s major flaw

To overcome the major problem with using the PE ratio, you can average a company’s earnings out over a number of years, say seven or ten years. This then takes into account the business and economic cycle.

You’d then divide the current share price by the average EPS. This gives you a cyclically adjusted PE (or CAPE).

The CAPE ratio shows you if shares in a specific company are genuinely cheap or expensive in comparison with its long-term average.

So there you have it. Why you should use the CAPE ratio to value a company instead of the PE ratio.

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