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About using the P/E Ratio...

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stervc Member Level  Monday, 11/29/10 08:55:32 AM
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About using the P/E Ratio...

The Price to Earnings (P/E) Ratio is a multiple to use for determining stock prices to convey the P/E Ratio as a general growth expectancy rate. The P/E Ratio is usually determined from an average of the top 20 to 30 companies in that particular Exchange/Sector/Industry.

It is assumed that each company within that Exchange/Sector/Industry will grow with the same expectancy rate under certain Fundamental Principles in relation with a company's Revenues, Expenses, and Outstanding Shares (OS) structure or its EPS to better put it. The P/E Ratio gives you an idea of what the investor within the market is willing to pay for a company’s earnings.

Consider below the P/E Ratio concepts of thought:

High P/E Ratio is Bad
Under this thought, investors see a stock with a high P/E Ratio as a stock that is overpriced. Investors believe that the stock is trading way to high given its fundamentals. Investors believe that the stock has grown way too fast and that the market will realize such and the price would drop to justify this thought.

High P/E Ratio is Good
Under this thought, investors within the market believe that high hopes exist for the stock’s future. It’s believed that the higher the P/E Ratio, the more growth potential it has within the market because it's showing growth higher than the average conservative market P/E Ratio. It is assumed that the company would continue its normal expectant growth rate. Investors are willing to pay more for a company’s earnings than what could be considered a conservative price to others because of where they believe the stock will be fundamentally going.

Low P/E Ratio is Bad
Under this thought, a low P/E Ratio would reflect that the investor has no confidence in the future of the company’s earnings and stock. It’s believed that the lower the P/E Ratio, the less growth potential it has within the market because it's showing growth lower than the average conservative market P/E Ratio. It is assumed that the company would not be able to continue its normal expectant growth rate. They believe that there is no market interest due to lacking fundamentals.

Low P/E Ratio is Good
Under this thought, investors believe that the stock is a sleeper that has been overlooked by the investors within the market. These are stocks that the investor believe they are finding before anyone one else does before they trade into a high P/E Ratio. Those supporting a low P/E Ratio believe that the lower a P/E Ratio, the more undervalued that stock is within the market as compared to normal growth expectancy rates from companies trading within their market.

As far as which thought is correct… I don’t know? There is no correct way in my opinion because there are too many variables that could change the way investors react and think to justify why they are buying a particular stock at the drop of a dime. I think people would be fair to themselves to be flexible in their considerations since you won’t know what actually the right way was until after the fact. It all comes down to what ”you” as an investor is willing to pay in a stock and their earnings.

It would be very ignorant of me to “finitely” state that your thoughts are right or wrong as a stock could be up on some days or down on some others. It will ultimately depend upon the substance that a stock continues to deliver to the market and how the market absorbs or interprets that substance delivered. Please understand that I have used these thoughts at one time or another primarily to help others understand the P/E Ratio logic and to also give me a bit of a mental refresher on the topic too.

In closing, I hope you see and understand why I think it was very fair for me to presume that 12 is a conservative P/E Ratio to use for my valuation posts with most stocks.

v/r
Sterling


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