PE Ratio Analysis in Stock Market

In many of my articles I talk about the PE or Price Earnings ratio, sometimes called PER in the UK. This measure is one of the most important and easiest ways to value the price of a stock. Using the PE ratio, you can make sure that you never over pay for a share and ensure that, over the long term, you will be handsomely rewarded for your pick.

So, what is the PE ratio?Although ofter quoted on web sites such as yahoo finance when you look up a stock, its simple to calculate yourself by taking the price of the stock and dividing by the earnings per share.

I like to think of the PE ratio in the following manner: if the company decided that it wanted to buy all its stocks back, the PE ratio is the number of years worth of earnings it would take. Therefor a company with a PE of 5 could pay for itself in 5 years whereas one on a PE of 50 would take 50 years. Obviously the lower the PE the better.

Why do people buy stocks on high PE ratios?The answer is usually that this high PE ratio is justified by the fact that the company is considered a ‘Growth’ company with the earnings expected to increase rapidly.

A good example of this is Google, on a PE of 45. It is expected that this company will keep growing rapidly along with its share price BUT in times of trouble, people often come to their senses and realize that such companies don’t deserve these high ratings and these types of shares often suffer the most.

Companies on low PE ratios are usually out of favor, often shunned by the masses for no good reason. Take my current favorite, RBS, it has double digit growth and makes huge amounts of money yet is on a lowly PE ratio of 7 which I consider unjustified.

The advantage of buying a ‘cheap’ stock is that in times of trouble, as they are already cheap and providing the other fundamental ratios are good, they have far less than they can fall. The price of RBS could fall by 50% but on a PE of 3.5 it would be the buy of your investing career, if Google halved I’m not sure I’d buy it on a PE of 22.5 as it could conceivably have further to fall.
The PE ratio is one of the most important ratios. I use it in both my HYP portfolio and when selecting value shares that usually go on to outperform market indices.

(Source: http://www.jargon-free.com/pe-ratio-explained/41/)