For example, if a company has a lot of products in the pipeline, I wouldn't mind paying a large multiple of its current earnings to buy the stock. It will have a large P/E. I am expecting it to grow quickly. A rule of thumb is that a company's P/E ratio should be approximately equal to that company's growth rate.PE is a much better comparison of the value of a stock than the price. A 10 stock with a PE of 40 is much more
"expensive" than a 100 stock with a PE of 6.
You are paying more for the 10 stock's future earnings stream. The 10 stock is probably a small company with an exciting product with few competitors.
The 100 stock is probably pretty staid - maybe a buggy whip manufacturer.
It's difficult to say whether a particular P/E is high or low, but there are a number of factors you should consider:
First:
It's useful to look at the forward and historical earnings growth rate.
If a company has been growing at 10% per year over the past five years but has a P/E ratio of 75, then conventional wisdom would say that the shares are expensive.
Second:
It's important to consider the P/E ratio for the industry sector. Food products companies will probably have very different P/E ratios than high-tech ones.
Finally:
A stock could have a high trailing-year P/E ratio, but if the earnings rise, at the end of the year it will have a low P/E after the new earnings report is released.
Thus a stock with a low P/E ratio can accurately be said to be cheap only if the future-earnings P/E is low.
If the trailing P/E is low, investors may be running from the stock and driving its price down, which only makes the stock look cheap.
