I use the P/E ratio as a secondary indicator for buying and selling stocks but I do not use the ratio in the same a manner as many value investors teach. I’ll explain the difference in my methodology for using the P/E ratio to your advantage.
Many value investors will pass on a growth stock which has a P/E ratio greater than a predetermined amount. By way of instance, they may discard all stocks with a ratio of 15 or greater, regardless of what industry group they come from. Some traders will discard any stocks that have P/E ratios over the market group averages, concluding they are grossly overvalued. I am not saying that this method does not work, as it does but it won’t work when you concentrate on purchasing young innovative small cap stocks which are growing at enormous rates, rates that”large caps” can no more sustain.
I have never passed on purchasing a stock as a result of its P/E ratio being too large. What is too large? Too large to one investor may be reduced to another investor. This is the same logic that I use when talking of stock’s prices. 1 difficulty that have with some value investors is their lack of understanding of the motion of their P/E ratio line on a graph. As a stock starts to move 100% or 200% from its pivot point, the P/E ratio will even move higher over the course of time. Plotting the P/E ratio on a graph will show you just how much of a profit the ratio has made since the stock continues its up-trend.
Value investors who pass on purchasing stocks with P/E ratio above a certain threshold have missed some of the biggest winners of all time (the 10-baggers as Peter Lynch would say). Analysts frequently downgrade stocks when their P/E ratios cross what they think to be fully valued thresholds.
Some things in life are worth more than anything else although they supply the identical use, like a car. I often use this case often but I’d rather have a Mercedes for $50k over a Pinto for $10k. They will both take me where I wish to go but I appreciate the amenities that the Mercedes provides me and the additional comfort, style and quality that comes with the luxury vehicle. The same is true for stocks, certain businesses offer greater appeal and are appreciated at greater ratios than their opponents. The greatest materialistic things in life, such as growth stocks, are often bought at a premium.
Growth stocks usually game higher P/E ratios compared to the rest of the overall marketplace, even at the beginning of up-trends. A top P/E ratio typically means that the inventory is enjoying strong demand. If a stock climbs in cost from 40 to 60, its P/E ratio also increases 50%. Despite the fact that the P/E ratio may be high according to some analysts and worth investors, the stock might be going to breakout from a cup-with-handle and go to double from this stage. Would you want to lose out on a potential 100% profit because the P/E ratio is too large?
Investor’s Business Daily conducted an outstanding case study in 1996-97:”The 95 best little – and mid-cap stocks of 1996-97 had a typical P-E of 39 in their pivot and 87 in the summit of their run-ups. The 25 best large caps of these years started with a typical P-E of 20 and climbed to 37. To get a bit of those big winners, you had to pay a premium.”
Once I buy a stock, I notice the existing P/E ratio and graph it together with the price. Historically, P/E’s that transfer up 100%-200% or more while the inventory is progressing, usually become vulnerable stocks and can begin to become flash and extended market signals. It holds true for a stock with a P/E beginning at 15 and visiting 40 or a stock using a P/E of 50 and visiting 115. Do not skip over EXCELLENT businesses which are growing at amazing clips due to a high P/E ratio. What may seem high today, could be low later on! Earnings and Sales are a lot more important. Cost and quantity are the most significant. The P/E ratio is no more than a secondary indicator which may be used to further assess the stocks in your portfolio.
Consistently use price and volume as your first line of defense and offense. From that point, turn to a dependable secondary signs to verify your original analysis and make a determination. I would never throw out a stock because its P/E ratio is too large. Take GOOG for instance, every value investor missed the 100% profit this stock boasted following the launch of its IPO. Growth stocks are expensive for a reason, remember the analogy into a Mercedes.