The Truth About P/E
Why a low price-to-earnings ratio may not be a bargain
By Ellen McGirt

(MONEY Magazine) – The most popular—and misunderstood—way to value a stock is to use the price-to-earnings ratio. According to financial analysts and cocktail-party pundits alike, a high P/E tells you that a stock is "overvalued" and a low P/E means it's "cheap." The virtue of P/E is its seeming simplicity: It's just stock price divided by earnings per share. The trouble is, like any kind of mental shortcut, the P/E ratio can be highly misleading. Someone who wants to sell you a stock can usually manage to, shall we say, massage P/E to fit his agenda. Here are four things you should know about the number.

AMAZON.COM One stock, two P/Es

P/E based on past earnings 47 P/E based on forecasted 34 Share price: $38 Past earning: $0.81 Forecast earning: $1.11

There are two kinds of P/Es—those based on the past four quarters of earnings and those that rely on a forecast of future earnings. "When someone wants to make a stock sound cheap they use projected P/Es," says Pat Dorsey, director of stock analysis for Morningstar. That's because in a growing company, next year's "E" is always bigger—unless, of course, the future doesn't work out as hoped.

WELLS FARGO Apples to apples

Wells Fargo trailing P/E 15 S & P 500 average P/E 18 Average for diversified banks 13

Let's say a broker tells you that Wells Fargo is cheap relative to the rest of the stock market. Sure enough, Wells Fargo has a trailing P/E of 15 vs. about 18 for the S&P 500. Here's the problem: Wells Fargo is a bank, and banks nearly always trade at a discount to the overall market. In fact, the average P/E ratio for the diversified banking sector is about 13 right now. That makes Wells Fargo look a lot less like a screaming deal.

NEWELL RUBBERMAID The wrong forecast

P/E based on forecasted earning 17 The real P/E, in hindsight 21 Share price on Jan. 1, 2003: $31 Forecast 2003 earnings: $1.80 Actual 2003 earnings: $1.49

So how good are those Wall Street forecasts? According to an analysis by StarMine, a firm that tracks equity analysts, 60% of companies report earnings below what analysts expected a year earlier. Consider Newell Rubbermaid. At $31 a share, the stock had a P/E of 17, based on the consensus of analysts. Turned out, Newell earned 17% less than they expected, so investors really paid 21 times earnings.

NEWMONT MINING Is lower always cheaper?

Be careful when using P/E to judge companies in cyclical businesses like autos, steel, paper or mining—anything that peaks and falls sharply in line with economic cycles. As such stocks soar, their P/Es sometimes shrink because their earnings are rising so fast. But those profits are usually bound to fall back just as dramatically. So it may be better to buy cyclicals when P/Es look high.

Note: As of Aug. 31. Source: Thomson/Baseline.