The following is an excerpt from “How to Use the Price/Earnings Ratio for Investing.“
Despite the analytical strength of the P/E ratio, this number has its limits.
“When you’re at the top of the economic cycle and profits are booming, a stock can seem artificially cheap, as the denominator – the ‘E,’ or earnings – is inflated. At the same time, near the bottom of the economic cycle, when profits are depressed, a cyclical stock can look expensive in P/E ratio terms because the denominator is temporarily depressed,” says Charles Sizemore, portfolio manager at Interactive Brokers Asset Management.
Those limitations underscore the benefits of using the Shiller ratio with a longer term earnings period. That smooths out the earnings number.
Additionally, it’s difficult to use the P/E for comparison across industries, as the metric can be industry specific. Software stocks usually have higher P/E ratios than slow-growing utility companies. So it’s best to compare P/E ratios within industries, Sizemore says.
Finally, it’s widely accepted that earnings can be manipulated. When that occurs, the P/E ratio may be less reliable.
Ultimately, the P/E ratio is a solid place to start an investment analysis for a quick valuation check of a market or stock. For best practices, add the P/E ratio to a more complete analysis of individual companies, industries and the economy.