Why is a low P/E Ratio in a stock supposedly a more secure investment ???

Question

I recently read in a book....that the the P/E Ratio really doesn´t assure you of anything...though i do wish to udertand it better..... doesn´t a low P/E Ratio been that the stock is ovarvalued....For it means that its earnings are too low?? I dont know im confused...please help me understand it....

Answer 1

Price to earnings is the relationship between the stock's price and their annual earnings per share (EPS).

So a stock that earns $2/share and sells for $60 has a P/E of 30.

The theory is if a stock has a low P/E, then it might be undervalued and eventually the stock market will realize this and the stock's price will increase.

However, you must be careful. Some industries have low P/Es in general and some (like some internet companies used to) have very high P/E ratios. So not only would you want to consider the P/E of the stock itself, but also the companies within the sector too.


FYI, using P/E ratio is an "old" way to pick stocks used for generations since other data on companies were not as easily accessible. Nowadays, selecting stocks is a much more refined process where you might consider earnings, earnings growth, sales, sales growth, insider trading, as well as a number of other attributes.

You might consider picking up How to make money in Stocks in good times and bad by William O'Neill whose CANSLIM method is very well known.

That'll help you get a good basic understanding of what makes a successful stock successful!

Hope that helps!

Answer 2

There are many different P/E ratios (trailing, forward, with accounting earnings, with earning from contious operations, etc) but that is a different story. For now lets just use the typical format:

P/E = Price divided by 12-months of Earnings

Therefore a Stock with a lower P/E will experience a smaller change in Price for the same amount of earnings change than a stock with a higher P/E. Unfortunatedly, that is bougus, a P/E is just a quick valuation measure and it should be used very carefully. Here is why:

The Price of the Stock (P) is equal to the Cash Flow that the owner of the stock will receive (now and in the future, most likely in the way of dividends) discounted by a rate (that encompasses the risk of invetsing in stock, instead of funding a CD for example). So,

P = Summation of all Cash Flows (D) discounted at rate (r). With some weird math and assuming the cash flow grows at a constant rate (g) you can get to the Dividend Discount model, which tells you that

P = D1 / (r - g) where D1 is next years divided.

So price really is not a function of earnings solely. Offcourse dividends are verey related to earnings but there is another factor g (or growth). Something that Wall Street LOVES!!!

Based on this, is the safe to argue that companies with high P/E are stocks that are expected to grow fast in the future and companies with low P/E will grow much much slower.

For example, Google's P/E is like 45 - 50 (HUGE!!!) that means, people expecte google to grow very fast. Now, GE's P/E is close to 15 (close to the norm), people expecte GE to grow with the economy (makes sense for such a big comapny).

Finally, smaller companies that are expected to grow a lot are very risky (or in other words, the volatility of their earnings or how their earnings move from year to year is very big). Bigger comapnies that grow with the economy will have smaller changes in their earnings (think blue-chips), therefore less risk. Which at the end means, less changes in the stock price.

Sorry for the long post, I hope it helps!

Answer 3

There are several different styles to use while investing. Investing in companies that have low P/E ratios are called value investors. They are looking for something with a low price per dollar of earnings. On the other hand, someone looking to invest in growth stocks would look for higher P/E ratios. These are companies that are reinvesting their money to grow (hence the "growth" style) their business.

Low P/E ratios tend to be more volatile. Here's why - a company with a P/E ratio of $10 faces a change in the market that affects their P/E by $1. That $1 change equates to a 10% increase in price to earnings. Apply a 10% increase to a company whose P/E is $30. This company would need a change of 3 times that of the low P/E company. In other words, volatility is less effective on the higher P/E ratio companies.

Is it really better to invest in companies with high P/Es? It's all relative to how you want to invest. If you want to make money quicker (and happen to hold the correct position in the stock), you will make more money with low P/E ratios than you would make with high P/Es. For the greater reward, however, you are assuming more risk.

Answer 4

The price to earnings ratio is how many times the earnings you have to pay to acquire the stock. At the extreme case, if there was a 1/1 ratio, then the stock earnings over one year would be as much as you pay, while if it was 1000/1 it would take 1000 years (not counting inflation). Make sense?

Answer 5

Well first thing is, you can only have a positive PE number if the company is making money. Use the P/E to get the PEG. Anything under a PEG of two would be listed as a buy. A PEG of 2 TO UNDER 4 is generally listed as a hold and 4 and up is often listed as a sell.
http://www.investopedia.com/terms/p/pegratio.asp

Answer 6

No. High P/E ratio means the stock is in demand and overvalued. People are willing to pay a higher price than the intrinsic value of the stock.