PE Ratio's: You're using them all Wrong!

PE Ratios

One of the most basic and widely used statistics in Stock evaluation is the P/E Ratio.  I’d like to add misused and useless ratio in determining Growth Stocks.  The PE (Price to earnings) Ratio is calculated by dividing the current stock price by the last 12 months earnings per share.

The PE ratio is supposed to be used as an indicator of a stocks “Value”.  For instance, if a stock has a PE ratio of 30 and its peers or industry average PE is 15, then the stock is considered “overvalued”.  Most Value investors will use this alone to make their sell decision.  No wonder so few people make money on a consistent basis in the market.  However if the stock PE is 20 and the industry average or stocks peers are 30, then the stock is considered “Under Valued”. 

If you are investing in stocks to make money, why would you buy a stock that has a low PE and wait for who knows how long for the market to “correct” the price of the stock (Price to go up)?  Not only does this tie up your money and for who knows how long but what’s to say the stock doesn’t become even cheaper?

Never buy a stock based on its PE ratio.  Just because a stock has a low PE doesn’t mean it’s a bargain and just because its ratio used to be higher and now is much lower doesn’t mean it can’t continue to go even lower.  There is usually a good reason its low and unless the company starts to grow earnings and sales at an accelerated pass, there’s no reason for the price go up.

The Stock market is an auction market place, meaning at any given time the market (buyers and sellers) are valuing a stock at what price they think it’s worth.  A stock with a PE ratio of 20 is “worth” 20x its earnings and a stock with a PE of 50 is “worth” 50x its earnings.  The bottom line is: you get what you pay for. 

The historically great Super Stocks were not found in the Bargain Bin, stocks that appreciate rapidly had other more significant data in common; EPS growth, high Relative Strength ratings and Big Volume % changes (Demand).

Based on studies of past winners, PE ratio’s had very little if any reason for effecting successful stock price appreciation.  Over the last 60 years the average PE of the best performing stocks was around 20 at the beginning of their move.  As these stocks advanced and appreciated in price, the PE expanded to around 45.  So what that tells you is all the Value investors out there that think stocks with high PE ratios that are “too expensive” missed out on most of the greatest stocks in history.

Super Stock example:  In December 1998, AOL broke out and started an unbelievable run.  The PE ratio of AOL at the beginning of its run was a whopping 158.  When AOL topped out in the summer of 1999, its PE ratio was a staggering 532!  The 158 PE may have seemed too expensive at the time but the buy point of AOL was $32 and peaked just shy of $180 a share six months later.

What the average investor, media and Value investors just don’t get is, you can’t buy a Porsche for the price of a Honda.  Great stocks, superstar athletes and talented employees always cost a premium.

The Super stocks over the last 60+ years have always had higher PE ratios than the market indexes and their PE continued to rise as earnings and stock prices climbed.

Some of the greatest Super Stocks in the 90’s that increased in value by 500% or more had an average PE of 31 when they broke out and ended with PE’s in the 70’s.  Investors trying to outsmart the market and buy “value” missed names like Cisco, AOL, Microsoft, Peoplesoft and many more.  Learn to buy companies with explosive Earnings growth and Sales Growth that lead their particular industry.  Remove Undervalued and Over Valued from your vocabulary. 

Google, another Super Stock broke out in 2005 at around $217 a share with a PE ratio of 74.  It climbed to $475 a share before pulling back.  Once again, using PE ratios to find Super stocks is pointless.  Don’t miss the next good based on some useless ratio!   Instead, Professionals and astute DIY investors use PE ratios as a selling tool.  Watch how far a PE ratio has expanded during the course of a stock run to gauge if the stock’s price rise has gotten, historically speaking, overheated. 

Pro Tip:  One useful strategy using PE ratios is to use it as a sell signal when it has increased by 130% or more from the stocks initial base breakout.  PE’s of Super Stocks usually expand 100% from their initial breakout to their final peak.

Welcome to the Nerdery,

Chad