Dont Buy Stocks based on P/E Ratio alone

I use the P/E ratio as a secondary indicator for buying and selling stocks but I don't use the ratio in the same a manner as many value investors teach. I will explain the difference in my methodology for using the P/E ratio to your advantage.

Many value investors will pass on a growth stock that has a P/E ratio higher than a predetermined level. For example, they may discard all stocks that have a ratio of 15 or higher, no matter what industry group they come from. Some investors will discard any stocks that have P/E ratios above the industry group averages, concluding that they are grossly overvalued. I am not saying that this method doesn't work, because it does but it will not work when you focus on buying young innovative small cap stocks that are growing at tremendous rates, rates that "big caps" can no longer sustain.

I have never passed on buying a stock due to its P/E ratio being too high. What is too high? Too high to one investor may be low to another investor. This is the same logic that I use when speaking of stock's prices. One problem that have with some value investors is their lack of understanding of the movement of the P/E ratio line on a chart. As a stock begins to move 100% or 200% from its pivot point, the P/E ratio will also move higher over the course of time. Plotting the P/E ratio on a chart will show you how much of a gain the ratio has made as the stock continues its up-trend.

Value investors that pass on buying stocks with P/E ratio's 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 believe to be fully valued thresholds.

Some things in life are worth more than other things although they offer the same use, such as a car. I tend to use this example often but I would rather own a Mercedes for $50k over a Pinto for $10k. They will both take me where I want to go but I value the amenities that the Mercedes gives me and the added comfort, quality and style that comes with the luxury vehicle. The same holds true for stocks, certain companies offer greater appeal and are valued at higher ratios than their competitors. The best materialistic things in life, including growth stocks, are usually bought at a premium.

The P-E ratio uses a stock's current price and divides it by total earnings per share over the past four quarters. For example, currently GDP has a P/E ratio 51.06 with a share price of $24.00. Its last four quarters of EPS add up to $0.47. Its P-E ratio is $24.00 divided by $0.47, or 51.06. MSN Money Central has the P/E ratio listed at 51.30.

Growth stocks usually sport higher P/E ratios than the rest of the general market, even at the start of up-trends. A high P/E ratio typically means that the stock is enjoying strong demand. If a stock climbs in price from 40 to 60, its P/E ratio also gains 50%. Even though the P/E ratio may be high according to some analysts and value investors, the stock may be about to breakout from a cup-with-handle and go on to double from this point. Would you want to miss out on a possible 100% gain because the P/E ratio is too high?

Investor's Business Daily conducted an excellent case study in 1996-97: "The 95 best small- and mid-cap stocks of 1996-97 had an average P-E of 39 at their pivot and 87 at the peak of their run-ups. The 25 best large caps of those years began with an average P-E of 20 and rose to 37. To get a piece of these big winners, you had to pay a premium."

When I purchase a stock, I note the current P/E ratio and chart it along with the price. Historically, P/E's that move up 100%-200% or more while the stock is advancing, usually become vulnerable stocks and can start to become extended and flash sell signals. It holds true for a stock with a P/E starting at 15 and going to 40 or a stock with a P/E of 50 and going to 115. Don't skip over EXCELLENT companies that are growing at amazing clips because of a high P/E ratio. What may seem high now, may be low later on! Earnings and Sales are much more important. Price and volume are the most important. The P/E ratio is just a secondary indicator that can be used to further analyze the stocks in your portfolio.

Always use price and volume as your first line of offense and defense. From this point, turn to some dependable secondary indicators to confirm your original analysis and then make a decision. I would never throw out a stock because its P/E ratio is too high. Take GOOG for example, every value investor missed the 100% gain that this stock boasted after the release of its IPO. Growth stocks are expensive for a reason, don't forget the analogy to a Mercedes.

Chris Perruna - http://www.marketstockwatch.com

Chris is the Founder and President of MarketStockWatch.com, an internet community that teaches you how to invest your money with solid rules. We don't stop at just showing you our daily and weekly screens, we teach you how to make your own screens through education. Through our philosophy, you will be able to create your own methods and styles to become successful.

---

Forces that Move Stock Prices

Among the largest forces that affect stock prices are inflation,... Read More

What the SEC Really Thinks About Mutual Funds!

Let's go into the details of why non-indexed mutual funds... Read More

True Investment Road Maps

If you don't know where you are going any road... Read More

Size Counts!

What the heck am I talking about?It is often said... Read More

Stops Make Money

During the day I watch CNBC-TV, the stock market channel.... Read More

Using Sector Funds to Construct Diversified Mutual Fund Portfolios

'Sector funds are too risky.' 'I doubled my money with... Read More

Investing in Dividend Paying Stocks

I was recently interviewed for a press release through a... Read More

Gurgle Gurgle

Caught in a whirlpool and being sucked under. No life... Read More

The POWER of a Proven Stock Investment Plan

When you invest in the stock market for ever-increasing cash... Read More

Eternal Sunshine

There is a current movie entitled "Eternal Sunshine of the... Read More

Downdraft

For the year 2000 we have seen hundreds of mutual... Read More

Trend Trading - Trading Stocks Using Technical Analysis and Swing Trading Strategies

Peter is a professional trader, Paul is not. Peter has... Read More

Investment Attorneys and Garbage Stocks

How is it possible that trash Companies are posting less... Read More

Stocks: Understand What You Buy!

"There is nothing more frightful than ignorance in action!" Johann... Read More

Tips to Finding Other People?s Simple Trading Plans

Did you know you can make money (and a lot... Read More

Exchange Traded Funds Primer

Exchange Traded Funds (ETFs) are a group of passive index... Read More

Trading Tips No 5: Stock Trading Curve Drawdown and Commitment

All stock trading and investing methods must deal with the... Read More

Your Job

There are so many kinds of work that needs to... Read More

Frog In The Pot

You remember the story about the frog that was put... Read More

Complacency Indicator

If you haven't heard of the technical indicator with the... Read More

Whos Calling?

Its dinnertime and the phone rings. It's Joe Noname with... Read More

The Holy Grail (of Investment)

Every year I go to the Money Show in Orlando,... Read More

Outsourcing

It's about time someone spoke the truth concerning outsourcing. The... Read More

Adding Funds

Someday you may want to retire and continue to live... Read More

Investment Clubs

Because you don't feel too sure about which stock or... Read More

Your Trading Objective: Why is that so Important?

You've decided to try your luck at trading stocks or... Read More

Is The Bear In The Cage?

For the last few weeks we have seen the stock... Read More

Take The Time

You must take the time once a month to review... Read More

Duck

Duck! No I don't mean a quack, quack. I meant... Read More

Choosing An Investment Stock Broker

If you want one.And I don't recommend any broker with... Read More

Making a Stock Watch List

I am taking the time to help others learn the... Read More

Jack and Jill

Jack and Jill went up the hill to fetch a... Read More

How To Buy And Hold

One of the most believed bits of conventional wisdom from... Read More