Cheap or Expensive

The P/E ratio is a much better indicator of the value of a stock than the market price alone, since it allows investors to make a better apples to apples comparison. For example, all things being equal, a $10 stock with a P/E of 80 is much more "expensive" than a $100 stock with a P/E of 15. That being said, there are limits to this form of analysis – it would be naïve to simply compare the P/E’s of two different companies to determine which is a better value without considering other factors. Two cardinal considerations are:

1. Company growth rates - How fast has the company been growing in the past, and are these rates expected to increase, or at least continue, in the future? Something isn't right if a company has only grown at 5% per year in the past and still commands a very high P/E. If projected growth rates don't justify the P/E, then a stock might be rightly overpriced. In this situation, you can calculate the “correct” P/E using projected EPS, and potentially sell short those shares until the stock price falls to the level that corresponds with the correct P/E.

2. Industry or Market Sector - It is most useful to compare companies if they are in the same industry. For example, utilities typically have low multiples because they are low growth, stable industries. In contrast, the technology industry is characterized by the potential for exponential growth rates and constant change. Comparing a tech company to a utility is useless. You should only compare high-growth companies to others in the same industry, or to the industry average. Comparing a P/E to the overall market is also useful to see if the P/E of a particular stock or industry segment is keeping up with broader trends.



Read more: P/E Ratio: Using The P/E Ratio http://www.investopedia.com/university/peratio/peratio2.asp#ixzz4hWuapuUU

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