Within equity analysis, the price-to earnings ratio is the most common calculation.

Key to any analytical style, it is one of the cornerstones for value investing.

Today we will look at the concept and its uses. We will also review some of the limitations of the price-to-earnings ratio.

Note that the examples below use real data from Yahoo Finance as at August 25, 2010.

**Price-to-Earnings Ratio**

Price-to-earnings (also seen as Price/Earnings or P/E) is a widely used fundamental.

To calculate, divide a company’s earnings per share (EPS) into its current share price.

For example, on August 25, 2010, Barclays PLC (stock symbol: BCS) traded at $18.46 per share. Barclays has trailing 12 month diluted EPS of $5.06. Therefore, the P/E ratio is 3.65.

Is that good or bad? I have no idea.

Never Look at P/E Ratios in Isolation

We need to look at comparative data.

That may be the company’s historic or expected future P/E ratios.

It may also be comparisons to key competitors, it’s industry, and sector of operation. Perhaps even to the market as a whole.

With Barclays, let us compare its P/E against competitors, industry and its business sector.

In the Financial sector, the average P/E ratio is 13.08. If Barclays traded at the same multiple, it share price should be $66 (BCS EPS of $5.06 * 13.08 Sector P/E).

In the more specific industry, Foreign Money Center Banks have an average P/E ratio of 7.4. That would translate to a share price of $37.

And of the 10 listed industry competitors, all but 2 have higher P/E ratios than Barclays.

Based on these comparatives, Barclays shares may have some value. Barclays $18.46 share price is vastly below both the sector ($66) and industry averages ($37).

But let’s look a little further.

In Investing, the Future is Always More Important than the Past

While the past is interesting, you need to always focus on the future.

This is true for any analysis, not just the P/E.

Barclays average estimated EPS for the year ended December 31, 2010 is expected to be $2.02. For 2011, the estimates are not much better at $2.73. Compare this at the $5.06 EPS today. A rather large decrease.

Even if we calculated the P/E ratio for Barclays using sector or industry averages, we might see the value in BCS begin to evaporate.

At an industry average P/E of 7.4, BCS would trade at $14.95 and $20.20 based on 2010 and 2011 estimates respectively. And at the sector level, BCS would trade at $26.42 and $35.71.

In this calculation, there appears to be some upside in Barclays’ share price over the next year.

**Problems with the P/E Ratio**

Garbage In – Garbage Out

Calculations are only as good as the quality of inputs.

If it were easy to properly estimate future earnings and price-earning multiples, one would be able to accurately chart future share price. And if this could be done, all the analysts would be at home getting rich, not crunching numbers all day in a tiny office or cubicle.

There are so many variables that need to be factored into a company’s future earnings that it is impossible to get them all right, or even close to right.

And there are always unforeseen events that take place to complicate things further. On September 10, 2001, I do not imagine many analysts factored in the next day’s terrorist attacks that impacted share prices across the board.

Both the number of variables and the possibility of unforeseen events occurring makes it very tough to accurately estimate EPS.

And the farther away the estimate, the greater the probability of error.

So when relying on someone’s estimates, never take them as the absolute truth.

Data is Fluid

The data impacting future earnings is always changing.

Each day new information is uncovered that affects a company’s future performance. The departure or a key executive, the announcement of a new contract for sales to China, a lawsuit against the company, etc.

With each piece of new data, the expected future results will change. As such, both future expected EPS and P/E for a company may be fluid and shift up and down over time.

No One Sees Things the Same

Different analysts may arrive at completely different conclusions, even given the same facts.

JPMorgan Chase has 25 analysts estimating its 2011 EPS. On August 25, the average estimate was $4.59. However, the lowest estimate was $3.30 and the highest was $5.35.

The difference is due to how each analyst interprets each variable.

Note that as to my point on data fluidity, if you review Yahoo Finance for the 2011 EPS estimates for JPMorgan, they may have already shifted by mid-September.

JPMorgan trades at a 10.59 trailing P/E ratio. If the ratio holds, one analyst has a target share price for the company at December 31, 2011 of $34.95. Another believes it will be $56.65.

Quite the different outcome for two investment professionals assessing the same raw data.

This is why investors religiously follow specific analysts who have excellent track records. And why these same analysts earn extremely high compensation.

Sometimes All Stocks Are Down

Even strong companies may fall in price.

In a bear (down) market, many stocks appear undervalued. But until the market, as a whole, improves and investors start to invest in equities again, the undervalued stocks may not increase in price.

In fact, they may fall even further.

Just because a good company has a low P/E does not mean it will rise in price anytime soon.

One needs to have patience when value investing.

Undervalued or Junk?

Investors value a company’s growth potential in the P/E calculation.

If investors believe the growth potential for a company is strong, it will have a higher P/E than one whose prospects are weak.

If you focus only on stocks with low P/Es, you may find some undervalued companies. But you may also end up investing in firms whose earnings potential is seen as weaker than in comparative companies.

Separating the value plays from the dogs is always a challenge.

The quantitative analysis may give the same results to two companies. But one may be a value stock, the other a piece of junk. That is why investors should never rely on P/E, or any ratios, on their own. They need to be combined with qualitative analysis ^{[4]}.

It is the qualitative, not the quantitative, analysis that separates the good from the bad.

I suggest you never forget that.

Next up, the price-to-book ratio.