Learn to value a stock · Day 4 of 28
When the P/E ratio misleads
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Key idea: P/E uses one year of profit. When that year is unusually good, bad or distorted, the ratio tells the wrong story.
Cyclical companies, such as chipmakers, steelmakers and carmakers, earn the most at the top of their cycle. That is when their P/E looks lowest, just before profits fall. At the bottom of the cycle profits shrink and the P/E looks sky-high, often when the shares are actually cheapest.
One-off items distort it too. A company that sells a division books a large gain, and its P/E drops for a year without the business changing at all. A large write-down does the opposite.
And if a company lost money, there is no meaningful P/E at all.
The fixes: look at several years of profit instead of one, use a mid-cycle figure for cyclical companies, and check the result against methods based on cash flow or assets. Equity Rank's model does the same, which is why a chipmaker's fair value can differ a lot from what its current P/E would suggest.
Quick check
A steelmaker's P/E is 5, its lowest in a decade, during record steel prices. What is the most likely explanation?
Read a worked example: valuing a cyclical at the wrong moment →
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Educational content only, not investment advice. Examples use made-up or historical figures.