Importance Of PE Ratio

'Buy low and sell high’ is the main principle to trade but the essence is to time you buy. To make money in a bear market, just buying and waiting isn't enough. You must buy only 'cheap' stocks. In order to get a sense of how expensive or cheap a stock is? you have to look at earnings relative to the stock price i.e the P/E ratio or the price-to-earnings ratio.

The P/E ratio indicates the value of a stock in relation to the company's earnings. The P/E ratio of a company is computed by dividing its share price with its latest earnings per share (EPS), which, in turn, is the net profit divided by the number of outstanding shares.A high P/E ratio suggests the stock is in great demand, or that the company has bright growth prospects or competitive advantages.

Though PE is a useful parameter a stock is not necessarily cheap when it has a low price-earnings (PE) multiple. A high-growth company may be cheap even at very high PE multiples.The P/E multiple represents the premium that the market is willing to pay on the earnings based on its future growth. The ratio is most often used to conclude whether a stock is undervalued or overvalued. In effect, the ratio uses the company's earnings as a guide to value it. A variant of the P/E - called the forward P/E - has also been developed wherein the current market price of the stock is divided by the expected future EPS.

Big increase in earnings is an important factor for share value appreciation. When a stock's P/E ratio is high; the majority of investors consider it as pricey or overvalued. Stocks with low P/E's are typically considered a good value. However, studies done and past market experience have proved that the higher the P/E the better the stock.

Various quantitative and qualitative factors that impact the company should also be taken in to consideration & should never make a stock decision solely on the basis of the P/E ratio. Always read the P/E ratio along with. First, one can obtain some idea of a reasonable price to pay for the stock by comparing its present P/E to its past levels of P/E ratio. We compare the P/E ratio of the company with that of the market giving a relative measure.

Investor has to attempt to purchase a stock close to what is judged as a reasonable P/E ratio based on the comparisons made.Though we have to pay a higher price for a quality company with quality management and attractive earnings potential in spite of P/E ratio factor.