Its pleasing simplicity and ease of application make the P/E ratio one of the most commonly used valuation metrics in the world. Almost every financial website, from Bloomberg to Google Finance, puts the P/E near the top of the page, right near the stock price and market cap. Investors constantly reference the P/E ratio when making a bullish or bearish case for a stock.
However, the vast majority of evidence suggests that P/E ratios are an unreliable way to measure the true value of stocks. There are several reasons for this misconception, including:
Accounting Rules Are a Moving Target
The earnings denominator of the P/E ratio is subject to accounting rules that are constantly being reshaped. Former Financial Accounting Standards Board (FASB) chairman Bob Herz expressed this sentiment to us when we spoke to him last year, saying:
“I’m not a big fan of earnings multiples, of P/E multiples and things like that. We have made over time dramatic changes in the accounting that affect the denominator of the P/E ratio, but it’s not clear whether and how that flows through the valuations.â€
The changing treatment of employee stock options is an example of how accounting rule changes affect reported earnings and make P/E’s between different stocks incomparable. One of the biggest in recent history was the 2006 FASB decision to require companies to report the cost of stock options on their income statements. This change officially went into effect in 2006. Unofficially, many companies reported stock option expense years in advance of the ruling.
For instance, Microsoft (MSFT) began expensing stock-based compensation in 2004. This expense lowered MSFT’s reported earnings decline by $1.8 billion in 2004 and made MSFT’s P/E incomparable to all other stocks that were not reporting their stock option expense.
Because companies have different fiscal year ends, the date they are required to follow new accounting rules is different too. So, at any given time, the EPS of some companies reflect the rule change while many others do not.
