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PE ratio
Is the PE Ratio the best method of deciding if a stock is worth buying?  Don't bet on it: PE ratio alone can be very misleading. 

The PE ratio is one of the most widely watched measures of valuation for both the stock market as a whole and individual stocks. Many investors use the PE ratio to determine if a stock- or the stock market as a whole- is expensive or not. For example, the average PE ratio for the S&P 500 index from 1950-2000 was 15.4. When the market peaked in early 2000 the PE ratio of the S&P 500 was a relatively high 30- suggesting that stocks were expensive.

The PE ratio (Price / Earnings ratio) is the price of a stock divided by past or future earnings (PE ratio = Price / Earnings).  Example, if the price of IBM is $100 and the company earned $10 per share over the past 12 months, then the trailing twelve month PE ratio would be $100 / $10, or 10.

When most investors think about stock valuation, there is one figure that springs to mind. Too often, it is the only one: the PE ratio, also called the price-earnings ratio. While it may be tempting to substitute that for real research, watch out: the PE ratio can be misleading. Even low-PE stocks can leave you with a queasy stomach when you later discover the reason they were so cheap. Likewise, a high PE doesn't necessarily mean a company's overvalued. There are plenty of good reasons why investors might want to pay a premium for out performance. 

Putting too much emphasis on PE ratios is especially misleading when companies miss their earning estimates.  Due to these hopefully temporary problems, the average company's PE ratios will be restated and in many cases accounting charges will also have to be taken.  The bottom line is that typically these companies will show an unattractively high PE ratio, and often will even have a loss. This, however, is usually only temporary, and typically reverses itself after a few short quarters. 

Consider the following: 
You are a young entrepreneur who decided to open a retail store.  After several years of hard work, you now own a chain of 5 stores, and are making a very nice living of $500K a year.  Now you are getting tired of running the business and decide to sell.  You call a business evaluator who estimates the value of your retail chain stores using the standard 2-3 times net earnings, or $1-1.5 Million.
Now imagine the same above scenario, but this time you are still excited about your retail concept and want to continue to expand. You decide to go public to raise money for future store development. You show a strong growth rate, Wall Street loves you and estimates the value of your company at 50 times earnings, or a cool $25 million dollars.
Now, does the above make sense?  Not to me, and not to anyone who ever ran a privately owned business.  Regardless, the above is the reality with respect to how stock values are determined on Wall Street.  So, the next time you try to make sense out of P/E ratios, just tell yourself, "It is not real; it is just a fantasy."

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