What is the P/E Ratio?
A P/E Ratio is the ratio between the market price for a stock (P) divided by the 12 Month Trailing Diluted Earnings Per Share (E)
|P/E Ratio =||Price per Share|
|12 Month Trailing Earnings per Share (EPS)|
A a low P/E ratio indicates that a company had high earnings given their stock price. Value based investors see low P/E ratios as a buying opportunity.
How should I use P/E Ratio?
Investors can use a P/E Ratio to judge how “expensive” shares are. A stock with a $100 share price and P/E Ratio of 75 is more expensive than a stock with a share price of $1000 and a Ratio of 12.
Stock market reporters widely tout the P/E Ratio, and it remains a top indicator for “value based” investors. By itself the P/E Ratio isn’t valuable. You need to compare it to the sector average and to specific competitors. Value based investors look to buy stocks that are worth less than the stock’s intrinsic value. If you see a company with a low ratio relative to its competitors, put it on your watchlist. You may want to buy it while stock’s price is low relative to its earnings.
You should use the indicator as part of a longer term strategy. Most value investors have a long time horizon, and are willing to wait until a P/E ratio approaches the sector average.
What traps should I avoid?
One trap that you need to avoid is the “Buy and hold forever” trap. Some investors will never sell a loser, but that is a mistake. P/E Ratio shouldn’t be the only criteria you use for investing. If you’re a value based investor, use the ratio, industry analysis and other financial indicators when you make an investment decision. A company with poor prospects is rarely a good investment no matter how low its P/E Ratio.
Another trap to avoid is depending on the P/E Ratio to understand short term fluctuations. In general, a P/E Ratio helps investors who want to take longer term positions. Investors who believe that stocks have some intrinsic value may rely on it heavily, with good reason. The ratio points out undervalued assets. However, active traders shouldn’t rely on it. A common trope in investing is, “The market can stay irrational longer than you can stay solvent.” Take this to heart when you plan to actively trade based on P/E Ratios. An “expensive” security (in terms of P/E Ratio) isn’t one that you should necessarily take a short position on. Active traders may want to use P/E ratios as part of their “Watchlist” criteria rather than as part of their investing decision criteria.