P/E Ratio: When it is and isn’t useful –

Been seeing a lot of people who just quote P/E ratio.

In-itself, P/E is just a metric and must be used in association with rather than being the sole decider of whether a stock is under or overvalued.

Businesses work in stages.

1. Stage 1: Intro stage – Here, it is R&D and their experimental product/service phase. They are likely losing tons of money and their P/E ratio will be negative despite being close to release.
2. Stage 2: Growth stage – Here, the company is ramping up production. Operating expenses are going to be high until they reach scaling. To reach scaling, they need to spend more money on expanding production capabilities. This will reduce their profits (if any) and result in a high P/E or negative P/E.
3. Stage 3: Mature stage – This is when a company has likely reached its mature stage. Production is scaled and efficiency is maximized to create profit and cash flow. This is the stage when it is best to use the P/E ratio because you are now comparing the efficiency of one company against another. At this stage, you can make a proper valuation with other tools on whether a company is overvalued or undervalued.
4. Stage 4: Declining stage – This is the stage where revenues are declining. Profits may still be up but because the stock price is falling due to negative sentiments and projected future of the company, the P/E ratio may still be high. Remember, P/E ratio is just a metric. It alone does not tell you whether a company is over or undervalued. It just spits out a number. As prices fall, the stock may seem undervalued but with declining revenues, profits are the next to go.
5. Stage 5: Death stage – This is when the company is pretty much on the verge of bankruptcy and will no longer exist in the future.

P/E ratio is useful but it's important to use it to compare companies in the same industry operating at the same stage of business. At the growth stage, a metric such as price-to-gross profit would be more useful than P/E, for example.