All about the P/E Ratio

The P/E ratio is one of the most commonly used ratios in Fundamental Analysis, and if you use it in your investing, you need to know the pros and cons of using it.  P/E ratio is defined as:

P/E Ratio = Market Value per share/ Earnings per share (or Current Price/EPS)

P/E gives us an idea about how a stock is valued compared to its earnings. P/E can be calculated on a Financial Year basis and this value is  indicated in the Investar Fundamentals Pane as P/E (FY). For decision-making purposes though, the FY P/E is not so useful as it is based on Financial Year data which does not change for almost a whole year, hence most analysts use trailing twelve months for the calculation. When calculated this way, the previous 4 quarters are used in calculating the EPS and in Investar, for example, this is known as P/E (ttm).  Because ttm values are more current, e.g., we use only ttm values for giving the advice in the Investar Expert Advisor.

But how does one use a P/E ratio? One common use is to compare it against an industry to see how a stock is relatively valued compared to its peers in the industry.

A lot of traders short stocks because of high P/Es and this is simply not a good idea because a lot of times P/Es are high because the company is growing rapidly and hence the high P/E can be justified. On the other hand, buying low P/E stocks is also not a good idea because as anyone who has been trading for some time knows, when a stock goes down it goes down for a good reason and it usually takes a long time to recover. Buying a low P/E stock could be akin to catching a falling knife. Although the Investar expert advisor gives a bearish rating to a low P/E or high P/E stock, we also recommend to check other fundamentals in the advice description mainly because we at Investar give less importance to P/E. It is not such a great indication of the fundamentals of the company. Rather than relying on P/E we feel it is much better to use a ratio called PEG, and we’ll talk more about that in a later post.