Sunday, January 17, 2010

How to decide a stock by PE ratio?

Click here for source.

Price Earning (P/E) Ratio is the most widely used ratio in investing. Searching the term 'P/E ratio' into Google will yield 2.3 million results. Quite simply, P/E ratio is the ratio of Stock price divided by its Earning per Share (EPS). If a company A is trading at $ 10 per share and it earns $ 2.00 per share, then A has P/E ratio of 5. This means that it takes 5 years for the company's earnings to pay up for your initial investment. If you invert P/E ratio, we get E/P ratio, which is the yield on our investment. In this case, a P/E of 5 is equal to a yield of 20%.

P/E ratio is convenient and very easy to use. But that is why so many investors misuse it. Here are some common misuse of P/E ratio:

Using trailing P/E. Trailing P/E is the price earning ratio of a company for the last 12 months. For cyclical companies coming off a peak in earning, P/E ratio is misleading. Trailing P/E ratio may look low but its forward P/E may not. Forward P/E is calculated by using the predicted earning per share of a company. Forward P/E is more important than trailing P/E. After all, it is the future that counts.

Neglecting Earning growth. Low P/E ratio does not necessarily means the stock is undervalued. Investors need to take into accounts the growth rate of a company. Company A with a P/E ratio of 15 and 0% earning growth may not look as appealing as company B with a P/E ratio of 20 and 25% earning growth. The reason is if both stock prices remain the same, after 3 years, P/E ratio of company B will decrease to 10.3 while A will still have a P/E ratio of 15. The moral of the story here is to not use P/E ratio alone to judge the value of an asset.

Ignoring One-Time Event. P/E ratio always includes one-time event such as restructuring cost or downwards adjustments in goodwill. When that happens, the 'E' in P/E ratio will appear low. As a result, this event inflates P/E ratio. Investors will do well ignoring this one-time event and look beyond the high P/E ratio.

Ignoring Balance Sheet. That is right. Investors often neglect the cash and long term debt embedded in the balance sheet when calculating P/E ratio. The truth is, companies with higher net cash in their balance sheet usually get higher P/E valuation.

Ignoring Interest Rate. Using solely P/E ratio for our investing decision will yield disastrous results. As explained earlier, when we invert P/E ratio, we get E/P ratio. E/P ratio is essentially the yield of our investment. A stock with P/E of 10 is yielding 10%. Stock with P/E of 20 is yielding 5% and so forth. If interest rate rises to 6%, then stocks that are trading at P/E of 20 will become overvalued, all else remains equal.

As with other financial ratios, P/E ratio cannot be solely used to value a company. Interest rate fluctuates, earning per share goes up and down and so does stock price. All these should be taken into consideration when choosing your potential investment.

You can find a lot other commentary at http://www.noviceinvesting.com All resources are offered for free.

Article Source: http://EzineArticles.com/?expert=Hari_Wibowo

5 comments:

Kamal said...

I am just a moderator of stock market now. Anyhow I will use your information for evaluating a company when I get into that and its useful.

Anonymous said...

removes the freons which are condensed in a cooled coil. When all the C F C gas has been collected the cooling flask around this coil is replaced with one http://buyviagraonlineauviagra-au.com#351 viagra online see Warhammer Battle Magic). The Phoenix Guard may increase their armour to heavy armour at a cost of +1 point per model. 0–1 UNIT OF WHITE LIONS OF http://buyviagra100mgcostviagraonline.co.uk#3,96547E+64264 buy viagra uk 651 A flat stomach should be part of a healthy physique

Anonymous said...

'' truth '' and we carry out an ordinary least-squares regression of C t on Y t, as shown in equation (3.9), then, assuming that we http://buyviagraonlineauviagra-au.com#393 viagra governors should know that they are responsible for understanding, complying with and enforcing national health and safety regulations. In most cases the 1988 Education Act offers blanket cover for http://buyviagra100mgcostviagraonline.co.uk#2757 cheap viagra 862 Growth hormones and antibiotics are avoided in favor of preventive measures like a balanced diet and clean housing to stop the spread of diseases in animals

Anonymous said...

So, are Omega 3 oils effective? Research has also found that Omega 3 plays a role in mental illness lumigan cost You should therefore avoid being idle
How to get soft skin is not by using substances on your skin that fail to adequately moisturize from the outside, and interfere with the production of moisture from within cheap cymbalta DBSA offers information on depression and bipolar disorder as well as listings to patient support groups across the USA
After having my knee replaced in 1999 and being told that I had to settle for swimming and biking only I set out to discover what else could be done to get my legs stronger again women Viagra uk In addition, elastin production is necessary
Your eyes will feel refreshed and your face will glow iressa cost Also known as the FBF diet for short, it is a program that has helped thousands of men and women burn body fat and get lean
A good herbal hair gel will have Aloe Vera as its base Emla Practically, this kind of system really helps to eliminate the dangerous bacteria that contaminate in our tap water

Anonymous said...

Fishes are rich in omega-3 fatty acids DHA and EPA which are proven to be helpful in supporting and improving the functions of the brain and reduce the deterioration of cells lumigan cost The positive thing about this is that you can practice this method at the comfort of your home
If we sit still, we stagnate cymbalta price 90% of all people who commit suicide have a diagnosable psychiatric disorder or depression.
3 buy viagra for women uk You should take into account that you will feel much better if you are drinking more water and you will find that your look much better also
In addition, I have become more familiar with new avenues to challenge the disorder in a positive way, I have seen results, some slow some quicker than other results show buy generic iressa Furthermore, the typical diet shuts down the metabolism to a very slow pace
There is no such thing as weekends off, the main thing to avoid is eating too much fatty foods and eating anything in excess Erythromycin Otherwise, you're just breaking down muscle mass and not giving the muscles the opportunity to develop