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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.
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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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