--- title: Quality of Earnings & Flaws of the P/E Ratio – Ben Rundle NAOS PM description: When analysts and market commentators talk about valuation of certain businesses, the method used is the price to earnings or P/E ratio. image: https://blog.naos.com.au/hubfs/Stock%20images/Blue%20shining%20fiber%20optic%20.jpeg --- ##### [Subscribe to NAOS NEWS & Insights](https://www.naos.com.au/subscribe) [![](https://assets.website-files.com/5b3d7f5582ecae7f1e026ce2/60be9de099c2716fb2efb4a7_naos.svg) ![](https://assets.website-files.com/5b3d7f5582ecae7f1e026ce2/640666256ede5e8ae8e33da0_B-Corp-Logo-Black-RGB.png)](https://blog.naos.com.au/) [Home](https://www.naos.com.au) About [About NAOS](https://www.naos.com.au/about-our-firm) [Our Team](https://www.naos.com.au/about-our-firm#people) [Why invest with NAOS](https://www.naos.com.au/about-our-firm#why-invest) [Our Investment Beliefs](https://www.naos.com.au/about-our-firm#beliefs) [Our Investment Process](https://www.naos.com.au/about-our-firm#how-we-invest) Listed Investment Companies [NCC: NAOS Emerging Opportunities Company Limited](https://www.naos.com.au/ncc-naos-emerging-opportunities-company-limited) [NSC: NAOS Small Cap Opportunities Company Limited](https://www.naos.com.au/nsc-naos-small-cap-opportunities-company-limited) [NAC: NAOS Ex-50 Opportunities Company Limited](https://www.naos.com.au/nac-naos-ex50-opportunities-company-limited) [Our Listed Investment Companies](https://www.naos.com.au/our-lics-compare-our-lics) [How to Invest](https://www.naos.com.au/our-lics-compare-our-lics#how-to-invest) Private Opportunities [NAOS Private Opportunities Fund](https://www.naos.com.au/npof-naos-private-opportunities-fund) [NAOS Ideas Network](https://www.naos.com.au/naos-ideas-network) E.S.G. 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Ideas agreement Investing in business innovation and financial commerce backing of creativity. Open lightbulb icon with gear mechanisms. Funding potential innovative growth -466788-edited.jpeg](https://blog.naos.com.au/hs-fs/hubfs/Stock%20images/Idea%20exchange%20concept.%20Ideas%20agreement%20Investing%20in%20business%20innovation%20and%20financial%20commerce%20backing%20of%20creativity.%20Open%20lightbulb%20icon%20with%20gear%20mechanisms.%20Funding%20potential%20innovative%20growth%20-466788-edited.jpeg?width=524&name=Idea%20exchange%20concept.%20Ideas%20agreement%20Investing%20in%20business%20innovation%20and%20financial%20commerce%20backing%20of%20creativity.%20Open%20lightbulb%20icon%20with%20gear%20mechanisms.%20Funding%20potential%20innovative%20growth%20-466788-edited.jpeg) Often when analysts and market commentators talk about valuation of certain businesses, the method used is the price to earnings or P/E ratio. A price earnings ratio is calculated by dividing the current share price by the earnings per share (EPS), For example, a company trading at $1.00 per share with 10c of EPS is trading on a PE ratio of 10 times. It is not uncommon for one to suggest that a company trading at a ratio 15 times is more expensive than a company trading on a ratio of 14 times, however that may not always be the case. The flaw with this method is that the ratio uses accounting earnings and not the cash the business receives. Due to the nature of accounting principles, companies have a degree of flexibility as to which items are included or omitted from accounting earnings. The software company sector is one which could catch investors unaware. These companies will often spend a great deal of money on research and development (R&D) each year to improve their product. As a general rule, R&D costs should be written off to the profit and loss account which would have an impact on accounting earnings by reducing the earnings per share and therefore increase the P/E ratio. However, under certain circumstances, for example if the R&D is only for one clearly defined project, the company may choose to capitalise these costs bringing them on to the balance sheet. In this scenario, accounting earnings have been improved and therefore the P/E ratio is lower which makes the company look cheaper than its peers. The key when looking at the earnings of a business  is to work out how much the business requires in capitalised expenditure each year to maintain its competitive position. Buffett talked through this concept extensively in his 1986 letter to shareholders and coined the term “owner earnings.” He summarised the issue by stating “The accountants' job is to record, not to evaluate. The evaluation job falls to investors and managers.” At NAOS we view ourselves as ‘value managers’ but it is not always the stock on the lowest price to earnings ratio or the lowest price to book ratio that represents the greatest value. When we look at a business we place a far greater emphasis on coming up with a value for what we believe the recurring cash flows look like and how they may be spent.   ###### [Articles of Interest](https://blog.naos.com.au/news-media/topic/articles-of-interest) [NAOS Insights](https://blog.naos.com.au/news-media/topic/naos-insights) ###### Share this post ### Comments ##### NAOS Asset Management ![](https://uploads-ssl.webflow.com/5b09df434e359cb73f2f80b5/5b09df434e359c362d2f81c4_location-icon-white.svg) Level 34, 25 Martin Place Sydney NSW 2000 ![](https://uploads-ssl.webflow.com/5b09df434e359cb73f2f80b5/5b09df434e359c121c2f81c8_mail-icon-white.svg) [enquiries@naos.com.au](mailto:enquiries@naos.com.au?subject=NAOS%20Website%20Contact) ![](https://uploads-ssl.webflow.com/5b09df434e359cb73f2f80b5/5b09df434e359ce0f62f81c9_phone-icon-white.svg) +61 2 9002 1576 ##### Our Listed Investment Companies [ASX: NCC - NAOS Emerging Oportunities Company Limited](http://www.naos.com.au/ncc-naos-emerging-opportunities-company-limited) [ASX: NSC - NAOS Small Cap Opportunities Company Limited](http://www.naos.com.au/nsc-naos-small-cap-opportunities-company-limited) [ASX: NAC - NAOS Ex-50 Opportunities Company Limited](http://www.naos.com.au/nac-naos-ex50-opportunities-company-limited) [NAOS Private Opportunities Fund](https://www.naos.com.au/npof-naos-private-opportunities-fund) [Listed Investment Companies](http://www.naos.com.au/our-lics-compare-our-lics) [Share Registry](https://boardroomlimited.com.au/) [Corporate Governance](http://www.naos.com.au/corporate-governance) ##### More Links [Privacy Policy](http://www.naos.com.au/privacy-policy) [Terms & Conditions](http://www.naos.com.au/terms-conditions) ##### Follow NAOS [![](https://uploads-ssl.webflow.com/5b3d7f5582ecae7f1e026ce2/5b3d7f5582ecae7e51026d27_twitter-icon-white.svg)](https://twitter.com/naosassetmgmt) [![](https://uploads-ssl.webflow.com/5b09df434e359cb73f2f80b5/5b09df434e359c11092f818c_facebook-icon-white.svg)](https://www.facebook.com/NAOSAssetManagement) [![](https://uploads-ssl.webflow.com/5b3d7f5582ecae7f1e026ce2/5b3d7f5582ecae133c026dca_Group%20261.svg)](https://www.linkedin.com/company/naos-asset-management) [![](https://uploads-ssl.webflow.com/5b3d7f5582ecae7f1e026ce2/5bf6115a4ae34255e68089e1_Asset%201Chart4.svg)](https://www.instagram.com/naos_asset_management/) Join our investment community. 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