The P/E ratio is one of the most useful metrics for determining how cheaply a company may be purchased. But as we’ve discussed before, it cannot simply be applied blindly; company earnings may be temporarily depressed, or may be high due to one-time gains. But even if earnings are corrected or smoothed to reflect fluctuations in the business cycle, a company’s balance sheet position may be so exceptional that it also has a material effect on a company’s would-be P/E.
Consider some of the strongest cash generating businesses in the world: Apple, Google, Microsoft, and RIMM. Their P/E’s will often look quite high at first glance, but in some cases they are much lower after adjusting for their cash balances. The chart below illustrates this, by showing these four companies (along with cash-rich KSW, a company we have discussed as a potential value investment) with their P/E’s after adjusting for their cash balances:
Clearly, the P/E ratio must be adjusted to become a meaningful figure. Furthermore, on its own it does not convey enough information to determine whether an issue warrants purchasing. The higher the P/E, the more earnings must grow to justify the price, and the more the stock price will fall if earnings growth does not come to fruition. This is why value investors prefer stocks with low P/E’s, as low expectations lower the potential for loss of capital and raise the potential for price appreciation.
Disclosure: Author has a long position in shares of KSW
