For many investors, the price-to-earnings (P/E) ratio is often the go-to metric when evaluating stocks. But while it’s widely used, relying on it too much can lead to misguided investment decisions.
“The P/E ratio has limitations. It doesn’t provide a complete picture of a company’s true value,” Henry Ong, a Registered Financial Planner, told FinancialAdviser.ph “Investors should consider other valuation tools instead of focusing solely on the P/E ratio.”
Here’s why the P/E ratio isn’t always the best metric—and what to use instead.
-
The P/E Ratio Can Be Misleading
At first glance, a low P/E ratio might seem like a bargain, while a high P/E ratio could suggest overvaluation. But this isn’t always the case.
“A low P/E ratio doesn’t always mean a stock is undervalued. It could be low because the company is facing financial trouble or stagnant growth,” Ong explains.
Similarly, some stocks trade at high P/E ratios because investors expect strong future growth, not because they are overvalued.
-
P/E Ratios Vary by Industry
A major flaw of using the P/E ratio as a standalone tool is that different industries have different average P/E ratios.
For example:
Tech companies often have high P/E ratios due to growth potential.
Utility stocks usually have low P/E ratios because they generate stable, but slow-growing earnings.
“Comparing P/E ratios across industries doesn’t make sense. A high P/E ratio in one sector may be normal, while a low P/E ratio in another may indicate trouble,” says Ong.
-
Earnings Can Be Manipulated
Since the P/E ratio is based on earnings, it’s vulnerable to accounting adjustments. Companies can inflate profits through one-time gains, cost-cutting measures, or aggressive accounting practices—making the P/E ratio unreliable.
“Earnings are not always a true reflection of a company’s financial health. Investors need to dig deeper into the company’s fundamentals,” Ong warns.
-
What Should Investors Use Instead?
Instead of relying solely on the P/E ratio, investors should consider:
Price-to-Book (P/B) Ratio – Best for asset-heavy industries like banking and real estate.
Price-to-Sales (P/S) Ratio – Useful for companies with inconsistent earnings.
Enterprise Value-to-EBITDA (EV/EBITDA) – More accurate for comparing companies with different debt levels.
Free Cash Flow (FCF) Analysis – Shows how much cash a company actually generates.
“A combination of valuation tools gives a more accurate assessment of a stock’s true worth,” says Ong.
The Bottom Line
The P/E ratio can be a useful starting point, but it shouldn’t be the sole factor in evaluating stocks. Industry differences, earnings manipulation, and financial limitations make it an incomplete valuation tool.
Smart investors use multiple valuation methods to get a clearer picture of a company’s real value. In investing, context matters more than just one number.
