Why is a low P/E ratio better than a high one?

Question

thanks

Answer 1

In his book "Contrarian Investment Strategies: The Next Generation," David Dreman does a good job of explaining his rationale for a low P/E stock selection strategy. On average, over long periods of time, low P/E stocks have outperformed high P/E stocks. There has been much debate over why this is, but I'd summarize Mr. Dreman's theory of why this works as the following. Analysts tend to be systematically too optimistic when forecasting companies' future growth rates. Therefore, they are willing to pay a high multiple of current earnings for these stocks. When it turns out they were wrong, the market strongly penalizes the prices of these high P/E stocks. There appears to be an asymmetric payoff between high P/E and low P/E stocks. When high P/E stocks report a positive earnings surprise, they don't go up as much as they decline when they report a negative surprise. The opposite is, on average, true of low P/E stocks. It is this effect that may explain why value portfolios often outperform growth portfolios. Turning to academia, a recent paper in the journal Review of Quantitative Finance and Accounting concludes, "Value portfolios outperform because of systematic errors in forecasting earnings growth rates."

Answer 2

P = price of stock and E = earnings per share
The best way to understand it is to plug in some ##s.
For example, if a company earns $10 per share then use a couple of possibilities like the price is $50 and maybe $100 . . .
so at $50 the p/e would be $50/$10 or 5
at $100 the p/e would be $100/$10 or 10
As the company earnings are the same at any given moment an investor would rather pay the lowest price , so would you rather pay $50 or $100 for the same $10 earning ? The lower P/E of 5 would be the better choice.
The same principal is true when comparing different companies too, the one with the lowest ratio is usually the better buy, the price of the stock relative to the company's earnings per share is better.

Answer 3

I think Darren has said all the things i just can add low P/E ratio is better for only those stocks which are expected to perform well in near future as their is room of profit to be made but a company which is in red and showing a very low P/E ratio that means something is wrong with their earnings. I hope you got it.

Answer 4

A low PE suggests that the company has had solid earnings in the past quarter. PE is calculated by dividing the share price by the earnings per share. So the lower the PE the higher the earnings were. It also suggests that a stock is not over priced or been inflated in value. PE is also good to use to compare similar stocks in the same industry as their PEs should be in the same range. The average PE is 19. However, companies that have expected growth, ie. Google, will have high PEs becuase their earnings are expected to grow so people are willing to pay a ot for the stock

Answer 5

Take P/E and invert it. That is 1/PE you will get the surrogate of Return on investment. This way you can see that low P/E means high ROI. This is one way to look at it.
Another way is it gives the earnings multiple meaning how many times the price is to the earnings per share or eps. Low P/E means the company is undervalued and has some way to reach the market average P/E so can be a good buy some time. Usually it is non Finance people who use P/E to pick stocks. Finance people use it as a first pass evaluation of candidate stock. Then they look at other fundamentals.

Answer 6

A low PE often does not suggest company has had good earnings recently. Likely the opposite. Market not capitializing the earnings highly as thinks they are 1-time or going to fall. While low pe is something to bring you to a stock there are many other factores pre-buy. Just asking this makes etfs & mutual funds a better choice for you. Don't trade - invest.

Answer 7

Risk reward ratio. There is more risk on a high pe stock. Risk that they will have a bad earnings report, risk that a new technology will gobble them up.

Low pe stocks have much of the risk already discounted. Not only that but many actually pay dividends. That tends to reduce downside risk.

Answer 8

Well a low P/E is better for somoene goigng long. Maybe if you want to short a stock, than look for one that has a P/E of 70! I like buying stocks with a P/E of around 15-20

Answer 9

Who says it is?

The P/E ratio ignores growth. Comparing the P/E of a growth firm to a mature firm is like comparing apples and oranges. The growth firm should have a higher P/E ratio -- and may actually be in better shape than a mature firm with a lower P/E ratio.