Unfortunately, the P/E ratio is not well suited to all companies or situations. Just take that last sentence from the paragraph above – there will always be companies that generate a loss or just barely break even. In such cases, P/E would yield a useless negative number, or no number at all if earnings are zero; even though the company may be a perfectly legitimate investment target that just happens to be in its early growth phase, or hitting a rough patch along with the rest of the economy. Below are some other possible pitfalls of using the PE ratio.
Why it’s difficult to determine “good” P/E
One limitation of the P/E ratio is that it cannot really be used to compare stocks across industries. This is because different industries are evolving and making money in different ways, resulting in varying growth prospects and profit margins. Manufacturers rely on expensive machinery, raising their capital costs; retailers simply buy products and re-sell them at thin but stable margins; IT or biotech firms rely mostly on brain power to reap profits on fast-growing but risky markets; while banks’ earnings depend largely on loan rates defined by the general interest-rate environment.
Such differences can result in substantial differences in average P/E among various sectors. For example, on US markets, the average forward PE ratio in January 2020 was 7 in the coal industry; 12 for banks; 16 for specialized retailers; 21 for auto and machinery makers; 32-35 for oil companies; 71 for healthcare products; and 77-101 for software developers. So you are better off using the P/E ratio only for apples-to-apples comparisons within one sector.
Another reason that an “ideal” P/E ratio remains elusive is that it also depends on the general market environment. As we saw in our discussion of the market context, a given P/E ratio can be attractive or unattractive depending on current government bond yields. And that’s just looking at one specific market; different countries have different risk-free interest-rate levels, making cross-border P/E comparisons difficult.
Value traps
Let’s say you come across a stock and conclude, after considering all that we’ve discussed so far, that its P/E ratio is low. Does this mean that the stock is undervalued and therefore a good buying opportunity? Not necessarily. If you ever shopped for anything in real life, you will know that some things are cheap for a reason; stocks are no different. A situation where an enticingly low valuation turns out to be a not-so-good investment is called a value trap. Often, a low P/E simply means that the market doesn’t believe in the company’s future earnings growth, or believes that the company is too risky. There could be several reasons behind this – perhaps the company is working in an industry or making a line of products that are becoming obsolete; perhaps it has new and aggressive competitors; perhaps it is caught up in a scandal and facing lawsuits; perhaps its credit rating has been lowered amid financial problems. So whenever you see a low P/E ratio, it is worth taking a closer look at the company’s fundamentals and its individual risk factors.
The PE ratio is also an imperfect tool for cyclical industries – such as the auto industry or commodities – where earnings depend just as much on longer-term economic cycles as on companies’ business skills and product quality. A company in a cyclical industry that is enjoying high profits at the peak of the cycle can also turn into a value trap.