Warning! Be careful of the P/E ratio when investing in ASX shares today

When investing in ASX shares, many investors go off the yardstick known as the price-to-earnings (P/E) ratio when valuing a stock.

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It’s a basic metric, but one that can be very useful in determining how the market is viewing different shares’ prospects for the future.

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But the current coronavirus situation and the adjoining stock market crash it has caused has changed the game. Therefore, using this metric for investing today is something you should be very careful of.

What is the P/E ratio?

It’s a simple ratio that divides a company’s share price by how much money the company makes for its shareholders (earnings). If a company is priced at $100 a share and brings in $10 of earnings per share, it will have a P/E ratio of 10 ($100/$10).

So a P/E ratio really represents what investors are willing to pay for a consistent dollar of earnings.

If a company is growing healthily, like CSL Limited (ASX: CSL), it will usually attract a higher P/E ratio (CSL’s is currently 38.23). Companies that investors think are going backwards, like Commonwealth Bank of Australia (ASX: CBA) right now, will attract a lower P/E (CBA’s is currently 11.65).

Most of the time (especially during bull markets), a company’s earnings remain fairly consistent in growing slowly over time. Obviously, this is more true for ASX blue-chips like Wesfarmers Ltd (ASX: WES) or Coles Group Ltd (ASX: COL) than for more speculative stocks like Afterpay Ltd (ASX: APT).

Thus, a company’s P/E ratio fluctuates more on the price that investors are willing to pay rather than the earnings the company makes.

But right now, this paradigm is being turned on its head.

That’s because many companies will take a huge, albeit temporary, hit when it comes to reporting their earnings for the first 6 months of 2020 (which are going to be rough for most companies).

This, in turn, means that the current P/E ratios (which account mostly for earnings from 2019) will be out of date very soon. And that translates into highly misleading P/E ratios right now.

Wesfarmers currently has a P/E ratio of 18.09, based on the trailing earnings per share of $1.93.

But say Wesfarmers (hypothetically here) only delivers $1.70 in earnings this year. That would put Wesfarmers on a new P/E ratio of over 20. Thus, the bargain you thought you were getting isn’t really there.

Foolish takeaway

So if you’re looking at your favourite ASX companies and seeing ‘attractive’ P/E ratios, think twice! You might not be betting the bargain you think you are. As always, invest for quality first and price second, and you should be ok.

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As of 17/3/2020

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Sebastian Bowen has no position in any of the stocks mentioned. The Motley Fool Australia’s parent company Motley Fool Holdings Inc. owns shares of CSL Ltd. The Motley Fool Australia owns shares of AFTERPAY T FPO and Wesfarmers Limited. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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