There is absolutely nothing wrong with doing your due diligence and researching company fundamentals when looking for a stock to buy. Heck, this should be a second nature activity if you are managing your own investing portfolio. However, one key thing to remember is that no one metric tells the full story about a stock on its own.
Popular fundamental metrics such as Return on Equity (ROE), Price Earnings (P/E) ratio, and Debt to Equity (D/E) ratio are commonly thrown around and used solely to describe the healthiness of a company, and to make investing decisions upon. However, an investor should try to see the full picture of a business by looking at multiple metrics to decide whether a stock is worth buying or not.
Probably the most common valuation metric used to determine the "Cheapness" of a stock is the P/E ratio. The Price to Earnings ratio simply measures the price of a stock in relation to its annual earnings per share. The earnings per share is just the net income for a fiscal year divided by the number of shares outstanding, or number of shares currently owned by shareholders. Many investors will use this metric and benchmark it against the overall index P/E ratio, or a comparable industry average P/E ratio, to decide if a stock is undervalued or overvalued. Because of it's simplicity and availability, this metric is widely used. However, P/E ratios have severe limitations on their own and should not be the "be all end all" valuation metric because if it was, then choosing stocks would be child's play.
Here is a simple example. Consider 2 stocks: RBC (RY.TO) and Pembina Pipeline (PPL.TO).
As of February 23, 2018:
RY.TO
Price: $102.56/share
EPS 2018 (Projected): $8.19
EPS 2019 (Projected): $8.80
P/E 2018: 12.52
P/E 2019: 11.65
Historical P/E Range: 8.359 - 15.01 (12.16 average)
Current Industry Average (Banks) P/E: 12.6
PPL.TO
Price: $42.49/share
EPS 2018 (Projected): $2.25
EPS 2019 (Projected): $2.53
P/E 2018: 18.88
P/E 2019: 16.79
Historical P/E Range: 9.562 - 52.91 (18.53 average)
Current Industry Average (Oil & Gas Midstream) P/E: 24.3
Current TSX Index P/E: 16.9
Now suppose you were trying to choose between the two stocks which one to buy based on P/E. Do you buy RBC because its current and projected P/E is lower than Pembina's P/E? Do you buy Pembina because it's P/E is lower than it's industry average P/E, unlike RBC to its industry average? Do you buy both because both have lower P/Es than the market average?
It's difficult to compare P/E ratios across industries because of the difference in underlying business operations, strategy, and company growth stage. Some companies operate with huge debt levels, some have no debt on their balance sheet at all, while others have a balance of debt and equity financing. What does a company's balance sheet look like if they are in its infancy and growing rapidly at 50% earnings a year as compared to a large blue chip stock like Canadian Tire? Comparing P/E ratios to the market is an okay comparison, but remember that the market ratios are an average over a large number of companies from various sectors and market caps, and won't be that relevant of a comparison to one particular stock.
Getting into more detail, P/E ratios can be even more misleading. Consider the formula for the ratio.
P/E: Stock Price/EPS
The stock price is equal to the present value of all anticipated future cash flows of the stock (i.e. dividends). Therefore, using a growing perpetuity formula (perpetual cash flows meaning infinite cash flows growing at a fixed annual rate and then discounted back to present time to account for inflation.... i.e. $1 dollar today is not worth $1 tomorrow):
P = Dividend in 1 year/(r -g)
where:
r= annual discount rate
g= annual growth rate of cash flows
We can expand the formula by saying that the dividend in 1 year is just equal to the dividend paid today multiplied by the annual growth rate:
P = Dividend today * (1+g)/(r -g)
The dividend is simply a fraction of the company's annual earnings, and therefore we can rewrite the formula to have dividends today equating to earnings today multiplied by the payout ratio:
P = Earnings * Payout Ratio * (1+g)/(r -g)
Rearranging the P and Earnings terms, we can see that now the underlying P/E ratio is a function of the payout ratio, annual growth rate of the stock's cash flows, and the discount rate of the cash flows:
P/E = Payout Ratio * (1+g)/(r -g)
The underlying equation equates to the P/E multiple, and therefore, using fixed P/E ratios means we are making assumptions about retained earnings payouts, the stock cash flow growth rate and discount rate. In reality, these metrics are difficult to estimate, and are usually derived based on projected future cash flows, risk free rates (government T-bill rates), stock Betas (riskiness of stock in relation to market), and expected market returns. By taking P/E ratios at face value, we are completely ignoring the impact of changing market conditions, interest rates, and potentially changing cash flow forecasts on the price and value of a stock.
The P/E ratio isn't a bad metric to use, but don't use it on its own, and understand its limitations. The same can be said for any stock metric: don't use any one metric at face value to make investing decisions. Consider other valuation metrics such as the PEG (P/E to EPS growth) ratio and EV/EBITDA (Enterprise Value to Earnings-Before-Interest-Taxes-Depreciation-Amortization) that may hone in more on fundamentals specific to that stock without having to make rash assumptions about forecasted company growth and inflation.
Having all stock fundamentals and metrics at your disposal is the only way to ensure you are making smart decisions of where your money is going to work. Otherwise, you may end up wasting your time on misleading information and becoming victim to analysis paralysis.