P/E ratios by themselves may not reveal much, since it usually needs to be seen in a particular context or compared with other companies. But still, here are some potential diadvantages of using this multiple.
When Relative Valuations Don't Work
A good example which I chance upon was on the Dotcom Bubble valuation in the year 2000. If you look at the chart, the NASDAQ matched the S&P until 1999, afterwards, the index shot up. After the huge sell-off, the NASDAQ matched the S&P again. During the bubble, the average P/E ratio was around 200, which can be intuited from how high the NASDAQ had soared. If you were looking at an internet stock with P/E ratio of 120 during the bubble, that stock would have seem undervalued. But once the market corrected, investing in that "undevalued" stock would have made a huge loss.
P/E Ratio Not Reflective of Company's "True" Earnings
The earnings of the company are not always reflective of the company's performance. This could be due to a few reasons.
One Time Gains / Losses: A company can make extraordinary gains or losses due to non-recurring or one-time events. For example, a law suit from another company could cause earnings to be depressed, or a huge sell-off of a business could be lead to huge gains. Looking at the company's net profit like that can be deceptive.
Accounting Estimates: Depreciation, amortization and asset write downs are all expenses which can result from management's estimates. This can dilute a company's true perfromance.
Cashflow: Profits don't recognise cashflow, such as capital expenditures or payment of debt.
P/E ratios by themselves may not reveal much, since it usually needs to be seen in a particular context or compared with other companies. But still, here are some potential diadvantages of using this multiple.
When Relative Valuations Don't Work
A good example which I chance upon was on the Dotcom Bubble valuation in the year 2000. If you look at the chart, the NASDAQ matched the S&P until 1999, afterwards, the index shot up. After the huge sell-off, the NASDAQ matched the S&P again. During the bubble, the average P/E ratio was around 200, which can be intuited from how high the NASDAQ had soared. If you were looking at an internet stock with P/E ratio of 120 during the bubble, that stock would have seem undervalued. But once the market corrected, investing in that "undevalued" stock would have made a huge loss.
P/E Ratio Not Reflective of Company's "True" Earnings
The earnings of the company are not always reflective of the company's performance. This could be due to a few reasons.
One Time Gains / Losses: A company can make extraordinary gains or losses due to non-recurring or one-time events. For example, a law suit from another company could cause earnings to be depressed, or a huge sell-off of a business could be lead to huge gains. Looking at the company's net profit like that can be deceptive.
Accounting Estimates: Depreciation, amortization and asset write downs are all expenses which can result from management's estimates. This can dilute a company's true perfromance.
Cashflow: Profits don't recognise cashflow, such as capital expenditures or payment of debt.