Should I only look at P/E ratio when valuing a stock?

Question

A company is earning 40 cents per share and is trading at $6.00. From there I get the P/E ratio to be 15. It does not have much growth potential and it's earnings are relatively stable and has been around 40 cents per share yearly and trading about $6 for sometime. Most of it's peers are trading at around a P/E ratio of 15.

They don't have any debt and their (hidden) assets/lands are valued at about $5 per share.

So I'm just wondering if the P/E ratio of 15 is really a good indicator of the share price? Because if you take into consideration the assets/lands then the share price should be about $11? Then the P/E ratio would be 11/0.4 = 27.5?

So when deciding whether or not to purchase the stock at $6, I get the P/E ratio to be 15, but assuming the share price goes up to $11 after the market factors in all their assets, the P/E ratio will be 27.5 (and earnings per share stays constant at 0.4), but will this share price be considered high because the P/E is 27.5, or can it be considered a fair/reasonable price? Because my thinking is I'm buying the assets/lands, in addition to earnings per share, is that correct logic? And would it really be waiting for 27.5 years before getting all my returns on investment back?

In other words, if a stock has say relatively low earnings per share, but it's assets are worth alot of money, and say the stock price goes high to reflect the assets real worth, the P/E ratio will be high. Will it be risky/worth it to invest in this stock if the assets are very highly valued as reflected in the share price, but earnings per share are low, thus giving a high P/E ratio?

Lets say this manufacturing company has no debt, and has a plant that is worth $5 per share, and I know this plant is really worth $5 per share and is not undervalued/overvalued in the accounting statements. It's earning per share is constantly 40 cents per share and the share price is $5. So the P/E ratio would be 12.5, but is the P/E ratio "really" 12.5? If I buy the stock at $5, I'm essentially just buying the plant at $5 per share and getting the earnings for free? Is it worth it to purchase this stock?

Answer 1

One problem is that P/E ratio only looks at the last announced earnings. Let's take your manufacturing plant with a P/E of 12.5. Then they announce a major problem that will hurt future earnings and the price drops in half. Now the P/E is 6.25. It looks great, but since there aren't any new earnings that reflect the problem, it's very misleading.

Answer 2

P/E ratio is useful but limited as others have said. Another problem is that it doesn't show leverage. Two companies in the same industry could have the same P/E but be differently leveraged. In that case I would buy the company with more equity and less debt as it should be a less risky investment. To compare companies and take leverage/debt into account you could use the EV/EBIT ratio instead. Its slightly more complicated to calculate and isn't presented by as many data sources though.

Enterprise Value (EV) can be said to represent the value of the company if someone would buy it today and then pay off all its (interest bearing) debt.

EV is essentially calculated like this: (Market Capitalization plus cash & cash equivalents) minus interest-bearing debt.

This is then divided by EBIT (Earnings before interest and tax) to get the ratio.

One drawback of this ratio though is that it can't be used for financials since their balance sheet pretty much consists of debt and the Enterprise Value therefore doesn't tell us very much. Also, like the P/E ratio it is dependent on fresh numbers. A balance sheet is just a glimpse of the companys financial situation on ONE DAY, and this could (and probably will, although not drastically for bigger companies) change to the next day.

Answer 3

P/E is undoubtedly a good and safe way to understand the market value of a stock. Statistics say that a US stock with a P/E value under 20 might be undervalued. This is said not to be true anymore. In fact we have today an overvalued SP500 with a lot of overvalued stocks that were set to lose value already some time ago but keep on rising due to their power to innovate. Extreme and trite examples are Tesla and Crispr. This 2 stock don't even have standard recurrent earnings to calculate a correct P/E on. From my experience, before buying a stock, and even when already holding it, checking P/E isn't wrong. The main contribution to the analysis of a single stock P/E comes from comparing a stock P/E to other competitors P/E. This is a simple task most investors skip. Your example of a company with no debt with a a plant that is worth $5 per share and so on, is an interesting way to demonstrate that fundamental analysis performed to make financial forecasts is possible but not always reliable. It would be too easy. Actually it is that easy but the stock market isn't always that rational. I believe technical analysis works much better in the medium time horizont.