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Why P/E Ratio isn’t the Key to Stock Selection

Are you of the opinion that a business with a low price-to-earnings ratio is a steal and a stock with a high P/E ratio is overpriced? When looking for stocks, here’s another way to look at it.

The P/E ratio is typically computed by dividing a stock’s current price by its earnings per share over the previous 12 months.

A frequent misconception is that stocks with low P/E ratios are inexpensive and should be purchased, whilst equities with high P/E ratios are overvalued and should be avoided.

Higher P/E ratios are more typical in bull markets, whereas lower ratios are more common in negative markets. Cyclical equities are an exception: they can have lower P/E ratios even in bull markets.

What You Pay For Is What You Get

Quality stuff has a higher price tag, and stocks are no exception.

The price of a stock reflects investors’ perceived value for the stock, which is determined by supply and demand. If investors believe a stock has substantial earnings growth potential, the stock price will rise.

Because the price is the numerator in the ratio, a greater price results in a higher P/E. Companies with flat profit growth and no catalyst to drive the stock upward are not a good buy if their stock price does not rise.

P/E ratios are high in high-growth stocks.

P/E ratios, according to IBD founder William O’Neil in his book “How to Make Money in Stocks,” will not tell you if a stock price will rise or fall, and the ratio should not be used to buy stocks. Earnings-per-share growth that accelerates or dramatically increases is a stronger metric.

If you looked at previous winners over the decades and screened out firms with P/E ratios higher than the market averages, you would have lost out on many major possibilities. According to O’Neil’s research, the best-performing equities had an average P/E of 20 when they began to gain ground from 1953 to 1985. At the same time, the Dow Jones Industrial Average had an average P/E of 15.

As these equities began to rise, their P/E ratios soared to roughly 45.

It was much more obvious from 1990 to 1995 when top growth stocks had an average P/E of 36 and even reached the 80s. The greatest performers began with ratios in the 25-50 range and progressed to a stratospheric 60-115 level. As you can expect, it was even more spectacular in the late 1990s, when prices skyrocketed.

If you passed up Microsoft (MSFT) in 2021 because of higher-than-average P/E ratios, you would have missed out on two opportunities. First, shares broke out of a cup base the week of June 25 when its P/E ratio was 37. The stock increased 16% till it peaked in August and began a new base.

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