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Why Look at a company’s PE ratio
The PE ratio tells you if a stock is overpriced when it is compared to its earnings. It is suppose to be a good indicator for weather a stock is undervalued or overvalued. By why does it work?
1. You want to invest in strong earnings
Obviously the more money a company is making the better an investment the company is in the long term. No one wants to invest in a company that isn’t making money. But everyone wants to invest in Coke or Google or any other large company making a ton of sales.
2. Prices act irrational
If the stock market always acted rational then there would not be any bulls markets or bears markets. Instead the markets would be flat and every time some news would come out about a company that company would adjust instantly. Because the markets don’t work this way prices fly all over the place. The PE ratio gives you a way to measure when the market has overreacted.
3. Dividends and growth
One side affect of looking at a company’s earnings is that a company’s earnings will influence how much dividend they can afford to pay. A company with high earnings can afford to give a much higher dividend to it’s shareholders then a company with low earnings. Earnings can also affect the growth of a company. As a company earns money they can reinvest it in themselves to grow even faster.
4. Everyone Looks At it
PE is one of the most looked at financial ratio when deciding if a company is a good buy or not. And the benefit of this is that in the stock market when everyone looks at something it becomes much more accurate.
If 30 million people are looking at something to decide if it is a great buy or sell it is going to have a lot more influence on the price of the stock then if 3 people are looking at it.
Editor's Note: This classic article on core Stock Advice, was originally published several years ago by unknown author. It has been reviewed, edited, and verified for accuracy and current market relevance by me, to ensure the highest standard of educational value. The original author of this artcile had website (active some years ago but downed/dead). stocks-simplified.com
Risk Management Advice
Crucial Advice: Effective trading is based on disciplined risk management, not prediction certainty. Always use a firm stop-loss to protect your capital. Macroeconomic news, particularly from the Federal Reserve or the European Central Bank, can override any technical pattern instantly.
About the Author
Ghulam Muhiuddin, Certified Technical Market Analyst
Experience: This analysis reflects the insights gained from 18 Years of consistent market analysis and forecasting, specializing in the application of the Elliott Wave Principle and advanced technical structures.
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