Dont Buy Stocks based on P/E Ratio alone
I use the P/E ratio as a secondary indicator for buying and selling stocks but I don't use the ratio in the same a manner as many value investors teach. I will explain the difference in my methodology for using the P/E ratio to your advantage.
Many value investors will pass on a growth stock that has a P/E ratio higher than a predetermined level. For example, they may discard all stocks that have a ratio of 15 or higher, no matter what industry group they come from. Some investors will discard any stocks that have P/E ratios above the industry group averages, concluding that they are grossly overvalued. I am not saying that this method doesn't work, because it does but it will not work when you focus on buying young innovative small cap stocks that are growing at tremendous rates, rates that "big caps" can no longer sustain.
I have never passed on buying a stock due to its P/E ratio being too high. What is too high? Too high to one investor may be low to another investor. This is the same logic that I use when speaking of stock's prices. One problem that have with some value investors is their lack of understanding of the movement of the P/E ratio line on a chart. As a stock begins to move 100% or 200% from its pivot point, the P/E ratio will also move higher over the course of time. Plotting the P/E ratio on a chart will show you how much of a gain the ratio has made as the stock continues its up-trend.
Value investors that pass on buying stocks with P/E ratio's above a certain threshold have missed some of the biggest winners of all time (the 10-baggers as Peter Lynch would say). Analysts frequently downgrade stocks when their P/E ratios cross what they believe to be fully valued thresholds.
Some things in life are worth more than other things although they offer the same use, such as a car. I tend to use this example often but I would rather own a Mercedes for $50k over a Pinto for $10k. They will both take me where I want to go but I value the amenities that the Mercedes gives me and the added comfort, quality and style that comes with the luxury vehicle. The same holds true for stocks, certain companies offer greater appeal and are valued at higher ratios than their competitors. The best materialistic things in life, including growth stocks, are usually bought at a premium.
The P-E ratio uses a stock's current price and divides it by total earnings per share over the past four quarters. For example, currently GDP has a P/E ratio 51.06 with a share price of $24.00. Its last four quarters of EPS add up to $0.47. Its P-E ratio is $24.00 divided by $0.47, or 51.06. MSN Money Central has the P/E ratio listed at 51.30.
Growth stocks usually sport higher P/E ratios than the rest of the general market, even at the start of up-trends. A high P/E ratio typically means that the stock is enjoying strong demand. If a stock climbs in price from 40 to 60, its P/E ratio also gains 50%. Even though the P/E ratio may be high according to some analysts and value investors, the stock may be about to breakout from a cup-with-handle and go on to double from this point. Would you want to miss out on a possible 100% gain because the P/E ratio is too high?
Investor's Business Daily conducted an excellent case study in 1996-97: "The 95 best small- and mid-cap stocks of 1996-97 had an average P-E of 39 at their pivot and 87 at the peak of their run-ups. The 25 best large caps of those years began with an average P-E of 20 and rose to 37. To get a piece of these big winners, you had to pay a premium."
When I purchase a stock, I note the current P/E ratio and chart it along with the price. Historically, P/E's that move up 100%-200% or more while the stock is advancing, usually become vulnerable stocks and can start to become extended and flash sell signals. It holds true for a stock with a P/E starting at 15 and going to 40 or a stock with a P/E of 50 and going to 115. Don't skip over EXCELLENT companies that are growing at amazing clips because of a high P/E ratio. What may seem high now, may be low later on! Earnings and Sales are much more important. Price and volume are the most important. The P/E ratio is just a secondary indicator that can be used to further analyze the stocks in your portfolio.
Always use price and volume as your first line of offense and defense. From this point, turn to some dependable secondary indicators to confirm your original analysis and then make a decision. I would never throw out a stock because its P/E ratio is too high. Take GOOG for example, every value investor missed the 100% gain that this stock boasted after the release of its IPO. Growth stocks are expensive for a reason, don't forget the analogy to a Mercedes.
Chris Perruna - http://www.marketstockwatch.com
Chris is the Founder and President of MarketStockWatch.com, an internet community that teaches you how to invest your money with solid rules. We don't stop at just showing you our daily and weekly screens, we teach you how to make your own screens through education. Through our philosophy, you will be able to create your own methods and styles to become successful.
More Resources
Unable to open RSS Feed $XMLfilename with error HTTP ERROR: 404, exitingMore Stocks & Mutual Funds Information:
Related Articles
Mutual Funds are Dead
You may have wondered why your mutual funds have been going down for the past 2 years. The answer is very simple, but not one you will hear from Wall Street as they want you to send money.
Getting Even
I know there are a lot of you out there who would like to "get even" with the stock market. Many are on the diet of "I hope, I hope".
Is Your Garage Full Of Junk?
I have a 2-car garage. There are nice shelves on one side and a good practical workbench with a vice on the other side.
Dispelling Illusions of the Stock Market
How can you dispel an illusion unless you look directly at it? The magician distracts the eye with one hand while he does his manipulation with the other. You are looking in the wrong place and not seeing what is actually happening.
Two for the Money
Look back over the years and try to remember how many different stocks and mutual funds you have owned. Suppose you had owned only 2 different equities during that entire time.
The Golden Goose is Sick
It is finally catching up with them. The brokerage companies I mean.
The Skinny on Mutual Fund Investing
Mutual fund investing is a lot like Thai cooking. Everyone has heard of it, most know a little something about it, but very few actually know how to do it and do it well.
Protect Your 401K
Checked your 401K lately? Going back to about a year ago many of these retirement accounts have shrunk by 30%, some even more. What Happened?You have been putting money in for years and your employer may have been contributing to your plan also.
Will the Stock Market be Lower in October?
The stock market often closes a week in the middle of a "perceived primary-trend range." SPX closed at about 1,234 Fri, which is between a multi-year Fibonacci level at 1,253 (i.
9 Deadly Trading Mistakes!
The following are a list of nine things you want to avoid at all costs. Anyone of them can literally destroy your financial dreams and goals!1.
KISS Formula
There are formulas for just about everything, but it has been shown that the simpler the formula or method of doing a particular task the better it works. It has evolved down to KISS - Keep It Simple Stupid.
"Fears Only Enemy Is Action"
What a great statement!I just heard someone use it in the context of personal and financial success and it struck me as a brilliant summary of an issue we raise in the SMG Tutorials.Fear is a huge issue with a lot of traders.
Trading as a Business
What can I expect to make my first year of trading?We get questions like this one quite often. We find that most aspiring traders don't have a clue as to what to expect from the market.
Parachute Investing
Ever jumped out of an airplane? It's OK if you have on a parachute. Pretty dumb if you don't.
The Next Bull Market
We are already in it, but you can't see it. It doesn't look like the one we had in '99.
Finding A Good Stock
One of the things people are always asking me is how can I find a good stock. The answer I give does not please them.
Stock Market System ... ONLINE STOCK TRADING ... Beyond Day Trading Basics & Tips
Day trading is all about making buy and sell decisions. When you make a trade either your going to lose money or your going to make money, and some other times you will break even.
The Importance of Using Stop Loss Orders When Spread Trading the Financial Markets
A Guide to Using Stop Loss Orders Stop losses are market orders designed to allow you to limit your losses.When you place a stop loss you are instructing the spread betting company or stock broker to cut your position when it reaches a certain loss level (or in some cases, profit level - more later).
Discipline
One of the great "secrets" of successful people is discipline and it doesn't make any difference whether it is manufacturing, processing, servicing or investing in the stock market.Before you can have that discipline you must have a successful plan and stick with it.
Adding Funds
Someday you may want to retire and continue to live in the life style to which you have become accustomed. According to conventional wisdom you will need less money because you will have fewer expenses than when you had to go to the office every day.