P/E: The Most Misunderstood Ratio in Finance
The P/E isn’t value. It’s a story.
Nature is too complex for our limited brains to fully grasp. So we cheat a little. We use models: simplified versions of reality. Not to tell “the truth,” but to make thinking possible.
George Box put it perfectly: “All models are wrong, but some are useful.” Useful because they capture just enough—and stay simple enough.
The price-to-earnings ratio (P/E) ticks those boxes. It claims to get a handle on something profoundly complex—the value of a business—by using something simple on the surface: a price divided by earnings.
However, its apparent ease of use has “democratized” it in a way that has distorted its original purpose—to the point that the P/E is probably the most misunderstood ratio in finance.
Not All Earnings Are Equal
Take two companies. Both trade at a P/E of 15, have the same market cap, and posted the same EPS last year.
On paper, they look comparable. But suppose I tell you that:
Company 1 sells software, with recurring revenue, strong customer stickiness, high margins, and …
