The P/E ratio can a great measure of value. The P/E ratio can a poor measure of value. It is both. You will get a distortion when earnings are not properly measured.
- No earnings problem - If there are no earnings or earnings that have just turned positive the P/E ratio will be distorted. Without some smoothing, the value can be a noisy signal.
- Accrual accounting - The difference between net income statement and cash accounting can be significant if there are significant accruals. A place for value fantasy is with bringing income forward that will not be earned until the future.
- Inclusion of equity investments - Non-realized gains and losses on investments as a part of income are causing more fluctuations in earnings that are unrelated. Equity investment fluctuations create noise versus what a company is earning on a cash basis
- One-time events - One-time events have to be taken out of numbers. They have an impact on cash flows, but valuation is about measuring the ability of a firm to make money through time and have assets that are mis-priced.
These accounting issues are critical for systematic investing that is looking for meaningful fundamental information. Without adjustment for all these one-off events, a model can just be an exercise in outlier detection.
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