As we saw last time, PE ratio is one of the most popular ratios used in determining the value of the stock. However despite its claims of helping you choose the bargain stocks, this ratio does have its own share of drawbacks. Here are the drawbacks of PE ratio
• PE ratio varies from sector to sector. A PE ratio that is considered high in one sector may be treated as low in another sector. E.g. IT companies usually have higher PE ratios than manufacturing companies. This is because IT companies are expected to show more growth over the period of time than manufacturing companies.
• PE ratio is not totally neutral. If the company declares it has received a new order or bagged a new client, is enough to send the PE ratio soaring.
• Also low PE may mean the lack of investor confidence in the company. It can imply serious problems with the company. So always find out more about the company’s background.
• One of the factors used in calculating EPS is assumed. It is based on the expectation of the company’s future performance. But this can be a problem as the company may not be able to continue with its good performance in future. Moreover the business in which the company is operating can experience problems. This happened recently in the real estate sector.
So when selecting the stock, don’t just take a look at the PE ratio. You also need to look at various other ratios and aspects. We will cover it in next posts.