Inputs

In practice, decisions must be made as to exactly how to specify the inputs used in the calculations. Does the current market price accurately value the organization? How is income to be calculated and for what periods? How do we calculate total capitalization? Can these values be trusted? What are the revenue and earnings growth prospects over the time frame one
is investing in? Was there special one time charges which artificially lowered (or artificially raised) the earnings used in the calculation, and did those charges cause a drop in stock price or were they ignored? Were these charges truly one-time, or is the company trying to manipulate us into thinking so? What kind of P/E ratios is the market giving to similar companies, and also the P/E ratio of the entire market?

A distinction has to be made between the fundamental (or intrinsic) P/E and the way we actually compute P/Es. The fundamental or intrinsic P/E examines earnings forecasts. That is what was done in the analogy above. In reality, we actually compute P/Es using the latest 12 month corporate earnings. Using past earnings introduces a temporal mismatch, but it is felt that having this mismatch is better than using future earnings, since future earnings estimates are notoriously inaccurate and susceptible to deliberate manipulation.

A Low P/E does NOT necessarily mean that the stock is UNDERVALUED

Merely because a stock is trading at a low P/E is not an indicator that the stock is undervalued. A stock may be trading at a low P/E because the investors are less optimistic about the future earnings from the stock.

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