A lot of investors specially those who called value investors love (P/E) ratio. They believe that whenever this ratio is below certain number which let say 10, it will be a good opportunity to pick a stock and invest on it, and the opposite is true once they found that this number is above 17 or 20 it will be an expensive stock and they will prefer not to invest in it and look for some other stocks.
Let me challenge this idea and provide you with two stocks for two different companies where, the first of which the P/E was below 10 and the stock was not good investment and the second of which the P/E was above 15 or higher than that and the stocks keep going up.
- Dell Tech, its P/E= (9.75) and its stock dropped from 67 $ to 49 $ and its keep dropping.
- Apple Inc, its P/E = (26.4) and its stock keep going up from below 200 $ per share up to 312 $ per share and above.
Investors should read this ratio or financial indicators the way it should. It is simply divided the price of stock on its earning and provide a value. This value increase when the price increase and decrease when the earning increase which is simple math. This ratio measure how much investor should pay for higher return or earning. Once he/she found the ratio is high that means price is higher to received earning which consider an overvalued investment, on the other hand when the ratio is small that means the price is low compared to the earning which consider an undervalued investment and good opportunity for investment.
But the question is what if the market is going up and there are some companies has low (P/E) ratio. What does that told us. It means that those companies are still struggling to make money and their stocks did not worth demand form investors which will lead to decrease in stocks prices and end up with low (P/E) ratio.
Another case where the (P/E) can misguided investors is where the market going through correction phase and investors come cross some company where its (P/E) ratio has not changed for long time and they think that this company is becoming undervalued since its (P/E) ratio has low value, and when the market finished its correction phase and start going up those investors notice those stocks they bought did not move with market and once the market become moving very fast upward those stocks barley move in up trend which was only a reaction to the market movement. And once something wrong happen that affect the market negatively those stocks will not stand that and will be the first to drop. That when those investors realize that they bet in the wrong horse by using the formula which supposed to be number one in picking the undervalued stocks.
(P/E) ratio was really the most valuable indicator that used by investors but that when they were checking the price in daily or weekly basis in newspaper but not after the internet ear and so many users can engage in millions of transaction in a day in stock market.
So the question now is what can investors do in order to use this indicators correctly and avoid been invested in bad companies which they are maybe about to bankrupted?
In order to use this ratio correctly and avoid been trapped in bad company’s stock you have to use it the way it should be which are as below:
- First investor should list the companies that have high earning in ascending order started from low earning companies to the high earning companies. Like for example if you have three companies A,B and C and their earning per share is A = 3, B = 2 and C = 5 , you should list them as below:
- B = 2
- A = 3
- C = 5
- These earnings should be better than the last quarter earning, which mean there should be an improvement in earning from last quarter by at least 75% because you know that earning is what matter.
- Let us assume that the stocks prices for each company above as below:
- A = 20 $
- B = 27 $
- C = 35 $
- The (P/E) ratio for all above companies are as followed
- A = 10
- B = 9
- C = 7
- Based in (P/E) ratio and how to choose the best undervalued company. Company C has lower ratio that is (7) even though its stock price is the highest price among other. That means the best minimum price investors can pay for high return is going to company C.
- That is not all. Investor now should compare (P/E) ratio of company C to the Sector that it belong to. If (P/E) of company C is equal to or higher than the sector (P/E) ratio that means C is one of the leading company on that sector and they should invest in it. But if C’s (P/E) ratio is way below the sector (P/E) ratio investors should know that this company is lagging company on that sector and they either should ignore this investment or wait until next quarter to see if there is an increment in company C (P/E) ratio to reach at least 9 with both increase in price and earning then they can invest in this company.
This is the right way for investors who want to use this ratio. They should use it as comparison tool between good companies which has improvement in earning, and they also should use it to indicate if the company they are about to invest in is leading company in that sector or lagging one. Also investors need to ignore this ratio or tool and never think to use it in bull market because once it used in any bull market whomever use it will end up with a company that struggle between a lot of success companies, which might be the start of this company to vanish from market.