Sunday 18 December 2016

Pitfalls of relying only on P/E ratios

P/E (price earnings ratio) is a measure often used and cited for stock analysis. Commentators will often appeal to the masses by quoting lines of: "Buy this stock now! It is selling at such a low P/E ratio" 

But is it a reliable measure? Let's use the complete past 3 year financial results (excluding one-offs) of Ezion Holdings and Penguin and the share price these companies were selling for slightly after the announcement of their full year financial results on the SGX.

FY end    Ezion EPSShare price (start Mar)P/E ratio

FY end  Penguin EPSShare price (start Mar)P/E ratio
 *All figures above are in cents. Share price data is from yahoo and has been adjusted for Ezion rights

If one notices, the P/E ratio had little correlation with how well the company did over the next financial year. In fact, if one had followed strictly by P/E ratio, we would all have bought in at the start of March 2014 and burnt a massive holes in our pockets. Since the start of March 2014 to now, Ezion and Penguin share prices have fallen 61.5% and 62.8% respectively.

The Missing Link

Using the power of hindsight, there is one important factor all investors should have noticed - business cycle

Both companies above belonged to the oil & gas industry and post March 2014, their earnings were hit by declining profits due to the down cycle of the O&G sector. Reputable financial institutions covering Ezion in March 2014 were touting it as a "buy", an "undervalued company" and unappreciated by the market. Penguin too was well covered in forums along the same line that it was an undervalued gem.

So are there any measurements to gauge the business cycle of any industry? Unfortunately, the answer is no.

To compound the misery, gauging the business cycle is a complete art. One has to walk the ground (surf the net) to understand the situation and draw your conclusions from it. And even then, one's conclusion could be faulty, leading to investment mistakes.

So before using the P/E ratio as our basis of analysis for a stock buy, it is perhaps good to pause and ask if its current P/E is justified by the impending developments of the industry it is in.

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