Should We Bother About Historical Price-to-Earnings Ratios?

Probably the most frequently used valuation tool among investors is the price-to-earnings ratio (P/E). The P/E ratio compares the price the company is trading at as compared to its earnings. This metric is used to compare companies with equivalent earnings potential.

Another way that investors like to make use of the P/E ratio is to compare the current ratio with P/E ratios of the past. Investors use past ratios to gauge whether the company is cheaper or more expensive than before. However, too often, I hear of investors misusing this metric.

Therefore, I would like to clarify when is the appropriate time to take historical measurements of P/E ratios as a benchmark and when we should ignore the past valuations.

When should we compare past P/E ratios?

The past P/E ratio is useful when comparing valuation of companies that have not changed much. Therefore, the current price of the company and its change in P/E ratio only reflects market sentiment and not changing fundamentals of a company.

In this instance, a company that is trading at lower P/E ratios compared to its past can be considered a bargain relative to what it used to trade at.

When is comparing past P/E ratios not useful?

On the other hand, comparing past P/E ratios is not useful when the company has fundamentally changed.

Too often, I hear investors telling me that company X is so cheap now because it is trading at a much lower P/E than its past. However, in reality, the company is really not all that cheap because its lower P/E ratio may be justified due to a change in the company’s fundamentals after all.

Take this example. A restaurant company had an average past P/E ratio of 15. However, this year, it reported that it was hit with an infection outbreak in one of its restaurants, causing brand perception to take a hit and loyal customers to stay away. As a result, the company expects sales and earnings to decline for the next few years. Investors, likewise, have priced this news in and the company now trades at a P/E of just 10. If you are an investor, you should not see this as a signal that the company is cheap. Instead, the new P/E ratio is justified due to its poorer earnings potential in the future.

The Foolish bottom line

Many investors broadly look at P/E ratios and compare them with the past to get a picture of the company’s valuation. However, there are other important aspects to look at before making any conclusion. Hopefully, this article clarifies this misconception and helps us make better decisions.


