Price/Earnings (P/E) ratios are a popular method of determining whether a stock is over-valued or under-valued. But according to Bennett Stewart, senior partner in the consulting firm Stern Stewart & Co., in a market where information is readily available the P/E ratio is too simplistic a measure to have any valid meaning. The P/E multiple is not the cause of a stock's price, but the consequence of it. And secondly, P/E multiples adjust to changes in the quality of a company's earnings, which makes earnings per share unreliable as a measure of value. In other words, the price of a company's stock is based on the company's growth potential and the quality of that growth potential relative to the risk. For example, companies with no debt typically have higher P/E ratios because risk is lower and investors do not require a premium. The same company with higher growth potential will have an even higher P/E ratio if that growth potential is well defined.
According to Stewart and an overwhelming body of established academic research, share prices are determined by expected cash generation from growth potential and not by reported earnings or the current book value of assets. That is why companies with bright prospects for long-run growth and profitability sell for the highest P/E multiples. However, regardless of whether you use earnings or cash flow to determine price, both are inadequate because neither tells you if the business is one that has sustainable growth. Without a way to measure growth potential itself, investing in a stock because its price is estimated to be $50 rather than $40 is mere speculation.