P/E Is Your BEST Friend. You Should Talk To Him.

Why the P/E Ratio matters more than you think...

Mar 31, 2025

Hi, Investor 👋

I’m Jimmy, and welcome to another free edition 🔓 of our newsletter. Today, we’re breaking down one of the most talked-about — and misunderstood — metrics in investing: the price-to-earnings (P/E) ratio.

It’s everywhere. It looks simple. But behind that one number lies a web of assumptions about growth, profitability, and risk — and if you don't unpack them, you could fall into a value trap.

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Bill Gates and Warren Buffett | Source: AI Generated, 2025.

In the world of investing, few metrics are as widely referenced as the price-to-earnings (P/E) ratio. It’s easy to find, simple to calculate, and commonly used to assess whether a stock is cheap or expensive.

But like any powerful tool, the P/E ratio is often misunderstood and misapplied, leading investors to draw misleading conclusions.

Understanding what the P/E ratio truly represents - and what it doesn’t - can make the difference between informed decision-making and costly mistakes.

The Illusion of Simplicity:

At first glance, the P/E ratio appears to tell a straightforward story:

A high P/E means a stock is expensive, while;
A low P/E suggests a bargain.

But this assumption is dangerously simplistic…

The P/E ratio is not just a number; it is a reflection of investor expectations about a company’s future earnings growth, profitability, and risk.

Treating it as an absolute measure of value without context is like trying to understand a novel by reading only the last page.

For example, two companies might have identical earnings per share (EPS), but vastly different P/E ratios. Why?

Because one company may be in a high-growth industry with strong profitability, while the other might be in a mature, low-growth sector (but there's a catch, which I'll explain below)…

Investors aren’t just buying earnings - they’re buying future potential.

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What Really Drives P/E Ratios?

At its core, the P/E ratio is a function of three key variables:

Growth Expectations (g): Companies with strong growth prospects tend to command higher P/E ratios. A business that can grow its earnings at 15% per year is inherently more valuable than one growing at 2%, all else being equal.
Return on Invested Capital (ROIC): This often-overlooked factor plays a crucial role in P/E ratios. A company with a high ROIC needs to reinvest less to sustain its growth, leaving more cash available for shareholders. This results in a higher valuation.
Cost of Capital (r): Investors require a return for taking on risk. If the expected return on a stock is lower than alternative investments, its price will adjust accordingly. Higher perceived risk leads to lower P/E ratios.

Many investors focus solely on growth (g) while ignoring the interplay between ROIC and the cost of capital.

This is a mistake.

A company can grow earnings rapidly but still be a poor investment if it requires excessive reinvestment to sustain that growth.

Conversely, a company with modest growth but exceptional ROIC can be a much better long-term bet.

Peter Lynch | Source: AI Generated, 2025.

The Trade-Off Between Growth and Free Cash Flow:

There is an inherent trade-off between growth and cash distributions to shareholders.

If a company reinvests all its earnings to drive future expansion, it sacrifices immediate returns to shareholders. If it distributes too much, it may limit its ability to grow.

The balance between these forces determines how much a stock is truly worth.

Consider two companies, both earning $1 per share.

Company A earns a high return on invested capital (20%) and only needs to reinvest 30% of its profits to sustain 6% annual growth. This leaves 70% of earnings available to distribute to shareholders.
Company B, with a lower ROIC (10%), needs to reinvest 60% of earnings to maintain the same 6% growth rate, leaving only 40% for shareholders.

Even though their earnings and growth rates are identical, Company A will likely have a higher P/E ratio because it generates more excess cash for investors.

This is why comparing P/E ratios without considering ROIC can lead to false conclusions.

A stock trading at 20x earnings isn’t necessarily more expensive than one trading at 12x - it may simply be a more capital-efficient business.

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The Flaws of PEG Ratios:

To address some of the limitations of the P/E ratio, investors often turn to the PEG (P/E-to-growth) ratio.

The idea is simple: if a company has a P/E of 20 and is growing at 10% per year, its PEG ratio is 2.0. A lower PEG ratio (typically below 1.0) is considered attractive. However, the PEG ratio has its own limitations.

The biggest flaw is that it assumes a linear relationship between growth and valuation.

But, as we’ve seen, not all growth is created equal.

A company growing at 15% with an ROIC of 25% is far more valuable than a company growing at the same rate with an ROIC of 10%. The PEG ratio fails to capture this nuance, making it an unreliable shortcut.

Using P/E Ratios the Right Way:

Instead of treating the P/E ratio as a standalone measure of value, investors should use it as a lens to understand market expectations.

If a stock trades at a high multiple, ask yourself: Is the market pricing in aggressive growth assumptions? Is the company’s ROIC high enough to justify this valuation?

Conversely, if a stock has a low P/E, is it a genuine bargain, or is the market correctly anticipating future struggles?

By deconstructing the P/E ratio into its components - growth, ROIC, and cost of capital - you can gain a clearer picture of what the market is really saying.

More importantly, you can determine whether the market’s assumptions are reasonable or misguided.

The best investment opportunities often arise when investors misjudge these relationships.

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Conclusion:

The P/E ratio is one of the most widely used and misused tools in investing. On its own, it tells you very little about whether a stock is actually cheap or expensive…

But when analyzed in conjunction with ROIC, growth expectations, and cost of capital, it becomes a powerful tool for uncovering opportunities and avoiding value traps.

Before making investment decisions based on P/E ratios, take the time to ask:

What assumptions are embedded in this number?
Is the market overestimating growth?
Is it underestimating a company’s ability to generate returns?

Only by answering these questions can you truly use the P/E ratio as a guide to making better investment decisions.

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