Is the P/E ratio redundant?

Burning Question proper size

The P/E ratio has been a useful tool for investors over a long period of time. It is easy to understand, can be quickly calculated and provides a snapshot of whether a company's share price is cheap or expensive.

However, with the world becoming more technologically advanced, the popularity of the P/E ratio seems to be falling. Today, investors seem to be increasingly interested in more advanced ways of deciding whether it is the right time to invest. They use models, algorithms and technical analysis, while others now focus on cash flow and other valuation methods rather than the humble P/E ratio.

Despite its falling popularity, the P/E ratio remains as useful as ever in assessing the appeal of a stock. As mentioned, it is universally understood among investors since it is simple, which makes it available to even the newest of investors. Certainly, modelling a company and forecasting its cash flows over the next ten years may prove to be a successful means of investing. However, for private investors who lack the time, knowledge or inclination to spend hours assessing the value of a stock, the P/E ratio provides convenience.

The P/E ratio also allows comparison between different sectors. Companies which are in fast-growing sectors such as technology may naturally have higher P/E ratios than defensive companies such as utility stocks. However, the P/E ratio nevertheless offers a direct comparison on the metric which all management teams and investors seek to deliver on; profitability. As such, the P/E ratio provides a quick indication as to which sectors offer good value for money and which are overvalued.

Different geographies can also be assessed easily using the P/E ratio. This allows for quick comparisons to find the best value indices in the world. Although other valuation methods can be used such as price to free cash flow, the reality is that over the long run profit and free cash flow should match up.

In other words, free cash flow and profit may differ in the short run due to the impact of accrual-based accounting. However, for long term investors net profit and free cash flow should be the same. As long as a company's cash flow is sufficient to keep it in business, using the P/E ratio to assess its valuation is a sound method.

Clearly, the P/E ratio is not a particularly complicated means of assessing a company's valuation. Nor is it perfect. Notably, it fails to consider a company's earnings growth rate, while stocks with strong balance sheets that could generate high levels of profitability in future are also penalised.

However, the P/E ratio offers a simple, quick and clear comparison between different companies. In an investment industry which often likes to add jargon and overcomplicate the obvious, the P/E ratio may be seen as a rather simplistic ratio. However, for long term investors with limited time, it continues to have significant appeal.

Could using the P/E ratio more frequently make you a millionaire?

Of course, finding stocks that are worth adding to your portfolio is a tough task, which is why the analysts at The Motley Fool have written a free and without obligation guide called 10 Steps To Making A Million In The Market.

It's a simple and straightforward guide that could make a real difference to your portfolio returns. As such, 2016 could prove to be an even better year than you had thought possible.

Click here to get your copy of the guide - it's completely free and comes without any obligation.

Read Full Story

FROM OUR PARTNERS