If you are stock investor, knowing what is PE ratio is a must. Actually this is called as:
P/E ratio or Price to Earnings Ratio = price per share / annual earnings per share
So if a price is trading at $36 per share and the annual earnings per share is only $2, it means that the:
Price to Earnings ratio = $36/$2 = 18
Some brokers or investors tempt you to buy along with them if the stock has a high PE ratio; it is because it seems to be a “good” investment. Frankly, it is either good or bad. And this is the truth. Why?
Below are the important things you need to know about PE ratio and how it should relates to your investing strategy:
Point #1: There is no such thing as “high” PE ratio; it needs to be compared with the “average” PE ratio of the industry sector where the company belongs.
So if the average PE ratio of the industry sector is 20 and the company PE ratio is at 15, then it is below average. So it is not considered as “high” PE ratio.
Point#2: If a company has a PE ratio of way above 25% than the industry average PE ratio, then it is considered as the best “candidate” for a good long term investment.
It is because PE ratio reflects the company performance in terms of earnings. So if the company is above 25% of the industry average PE ratio. The company is considered to be one of the industry or sector leaders which have long term financial life.
Point#3: Even though a high company is considered to have a “high” PE ratio as compared to the industry average. It is considered to be a riskier form of stock because of very high expectations set to it by the rest of the investors and in the industry.
So it means that a single bad news or negative news can severely affect the stock growth and profitability.
Point#4: A high PE ratio means that the stock is possibly overvalued. An overvalued stock is risky because the high PE is not a perfect indicative of the company actual financial performance. This figure can be misleading and manipulated easily because they might be reporting or using different earnings per share computation.
Thus it is best to compare the stock with other factors (such as earnings growth), and not only PE ratio.
Point#5: If the stock has high PE ratio and way above the industry average PE ratio, and also has predictable earnings growth per year, then it “might” look a good long term investment.
There is still a risk involved here, try reading below why buying high PE ratio stocks is NOT advisable: