Technical analysis 101: PE ratio, Pros /Cons and Cases

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Price to Earnings ratio is calculated as follows:

P/E Ratio = Stock Price / Forward Earnings Per Share (EPS)

The P/E ratio is widely used for several reasons:

Strengths:

a. Ease of calculation: The P/E ratio only requires two readily available data points - stock price and earnings per share.

b. Simplicity: The metric is easy to interpret, as it represents the price an investor is willing to pay for each dollar of a company's earnings.

Weaknesses:

a. Manipulation of EPS: Earnings per share can be manipulated through various accounting practices or non-recurring items, affecting the reliability of the P/E ratio.

b. Non-cash items: The P/E ratio does not account for non-cash items like depreciation and amortization, which can significantly impact a company's financial performance.

Let's explore these aspects further with some real-life examples and quantitative analysis.

Case 1: Apple Inc. (AAPL)

As of September 2021, Apple had a P/E ratio of around 28. Considering the historical average P/E ratio for the S&P 500 is approximately 15-17x, Apple's P/E ratio might seem high. However, we must consider Apple's growth potential and strong financials, which have led investors to be willing to pay a premium for the company's shares.

Case 2: General Electric (GE)

In contrast, General Electric had a P/E ratio of around 23 in September 2021. Although this P/E ratio is lower than Apple's, it may not necessarily indicate a better investment opportunity. GE's financial performance has been lackluster in recent years, and the company has faced numerous headwinds. In this case, the P/E ratio could be misleading due to GE's lower growth prospects and financial stability.

Quantitative Analysis:

To further illustrate the importance of context when using the P/E ratio, let's examine the P/E ratios of different sectors. As of September 2021, the Information Technology sector had an average P/E ratio of 36.07, while the Energy sector had an average P/E ratio of 18.46. 

This indicates that P/E ratios can vary significantly across industries, and comparing companies within the same sector can provide more insightful information.