Price to Earnings Ratio Isn’t A Magic Wand

Price to earnings ratio (P/E ratio) might be the first tool we learn about when investing. After all, the information is easily available and very easy to relate to. However, as investors, we should not become a man with a hammer. To a man with a hammer,

everything appears to be a nail. If P/E ratio is the only tool we know, we might view all companies in term of their P/E ratios.

However, there are some companies where using P/E ratios might be ineffective. There are companies that rise and fall with the respective business cycle or economy. Some examples of such companies are businesses in the retail sector, things that the buyers can and will cut back on during times of recession.  We can be talking about companies such as SP Setia (SPSB:MK), one of the largest property developers in Malaysia.

During an economy boom, people might have the ability to purchase new houses and other assets investment. However, during an economy slowdown, people might cut back on their home purchase and the company will see a huge decline in profits. Similarly, companies such as Bonia Corp (BON:MK), a fashion retailer will face revenue drop during recession when consumer cut back on their discretionary purchases.

Why is this a problem then? Because during the peak of its business cycle, the company will be making record profits, resulting in a very low P/E ratio for its shares. However, that is actually the most dangerous point of investing into the company. One the other hand, when the company is in its low point of its business cycle, it will have weak profits, resulting in a high P/E ratio.

Value In Action

Although P/E ratio is a very effective method to value a company, we have to take note of its limitations. Understanding the economics of the business is as important as the valuation estimation of a company.

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The information provided is for general information purposes only and is not intended to be any investment or financial advice. All views and opinions articulated in the article were expressed in Stanley Lim’s personal capacity and do not in any way represent those of his employer and other related entities. Stanley Lim doesn’t own shares in any companies mentioned above.

 

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