The importance of P/E ratio
There are many approaches and various ratios one can utilize when evaluating stock, but the price/earnings (P/E) multiple is one of the most important determinants of stock performance and has a direct bearing on the price behavior of a share of stock: other things being equal, as the P/E ratio moves up (or down), so does the price of the stock. It's a key variable in determining the amount of capital gains a stock is capable of producing and, as a result, has a substantial impact on defining a stock's return potential. In fact, it's the centerpiece of the so-called P/E approach, which uses a stock's price/earnings ratio to determine whether the stock is fairly valued.
The Earnings multiplier approach shows you the multiple you're paying for each dollar of earnings of the company. All things being equal, one would prefer a company with a lower P/E than a higher P/E. You are willing to pay a premium P/E multiple for a rapidly growing company because you expect its future earnings rate to be higher. A good rule of thumb is that a stock is attractive if its P/E ratio is lower than its long-term compound growth rate in EPS. Conversely, if the company's outlook is more uncertain due to factors such as competition, a lawsuit, or a cyclical downturn, then you may wish to discount your valuation expectations by insisting on a lower P/E multiple.
Comments
hi
q. would this example be a proper implementation of your concept
p/e ratio - 0-10
Earnings Per Share Growth 10-50%
thanks
Posted by: david sandel | February 1, 2007 08:58 PM
Yes, David, that is a good example. If the EPS growth rate is that high, and the P/E ratio is quite low in comparison to its peer, the stock would be attractive.
Posted by: ibooyah | February 1, 2007 10:47 PM
thanks!
Posted by: david sandel | February 3, 2007 10:13 PM