Dont Buy Stocks based on P/E Ratio alone

I use the P/E ratio as a secondary indicator for buying and selling stocks but I don't use the ratio in the same a manner as many value investors teach. I will explain the difference in my methodology for using the P/E ratio to your advantage.

Many value investors will pass on a growth stock that has a P/E ratio higher than a predetermined level. For example, they may discard all stocks that have a ratio of 15 or higher, no matter what industry group they come from. Some investors will discard any stocks that have P/E ratios above the industry group averages, concluding that they are grossly overvalued. I am not saying that this method doesn't work, because it does but it will not work when you focus on buying young innovative small cap stocks that are growing at tremendous rates, rates that "big caps" can no longer sustain.

I have never passed on buying a stock due to its P/E ratio being too high. What is too high? Too high to one investor may be low to another investor. This is the same logic that I use when speaking of stock's prices. One problem that have with some value investors is their lack of understanding of the movement of the P/E ratio line on a chart. As a stock begins to move 100% or 200% from its pivot point, the P/E ratio will also move higher over the course of time. Plotting the P/E ratio on a chart will show you how much of a gain the ratio has made as the stock continues its up-trend.

Value investors that pass on buying stocks with P/E ratio's above a certain threshold have missed some of the biggest winners of all time (the 10-baggers as Peter Lynch would say). Analysts frequently downgrade stocks when their P/E ratios cross what they believe to be fully valued thresholds.

Some things in life are worth more than other things although they offer the same use, such as a car. I tend to use this example often but I would rather own a Mercedes for $50k over a Pinto for $10k. They will both take me where I want to go but I value the amenities that the Mercedes gives me and the added comfort, quality and style that comes with the luxury vehicle. The same holds true for stocks, certain companies offer greater appeal and are valued at higher ratios than their competitors. The best materialistic things in life, including growth stocks, are usually bought at a premium.

The P-E ratio uses a stock's current price and divides it by total earnings per share over the past four quarters. For example, currently GDP has a P/E ratio 51.06 with a share price of $24.00. Its last four quarters of EPS add up to $0.47. Its P-E ratio is $24.00 divided by $0.47, or 51.06. MSN Money Central has the P/E ratio listed at 51.30.

Growth stocks usually sport higher P/E ratios than the rest of the general market, even at the start of up-trends. A high P/E ratio typically means that the stock is enjoying strong demand. If a stock climbs in price from 40 to 60, its P/E ratio also gains 50%. Even though the P/E ratio may be high according to some analysts and value investors, the stock may be about to breakout from a cup-with-handle and go on to double from this point. Would you want to miss out on a possible 100% gain because the P/E ratio is too high?

Investor's Business Daily conducted an excellent case study in 1996-97: "The 95 best small- and mid-cap stocks of 1996-97 had an average P-E of 39 at their pivot and 87 at the peak of their run-ups. The 25 best large caps of those years began with an average P-E of 20 and rose to 37. To get a piece of these big winners, you had to pay a premium."

When I purchase a stock, I note the current P/E ratio and chart it along with the price. Historically, P/E's that move up 100%-200% or more while the stock is advancing, usually become vulnerable stocks and can start to become extended and flash sell signals. It holds true for a stock with a P/E starting at 15 and going to 40 or a stock with a P/E of 50 and going to 115. Don't skip over EXCELLENT companies that are growing at amazing clips because of a high P/E ratio. What may seem high now, may be low later on! Earnings and Sales are much more important. Price and volume are the most important. The P/E ratio is just a secondary indicator that can be used to further analyze the stocks in your portfolio.

Always use price and volume as your first line of offense and defense. From this point, turn to some dependable secondary indicators to confirm your original analysis and then make a decision. I would never throw out a stock because its P/E ratio is too high. Take GOOG for example, every value investor missed the 100% gain that this stock boasted after the release of its IPO. Growth stocks are expensive for a reason, don't forget the analogy to a Mercedes.

Chris Perruna - http://www.marketstockwatch.com

Chris is the Founder and President of MarketStockWatch.com, an internet community that teaches you how to invest your money with solid rules. We don't stop at just showing you our daily and weekly screens, we teach you how to make your own screens through education. Through our philosophy, you will be able to create your own methods and styles to become successful.

Law School to Provide Tax Help Inside INdiana Business (press release), IN - Jan 5, 2009 Taxpayers with annual income of $42000 or less are eligible for the help if they have not received income from the sale of stocks, mutual funds or homes or ...

$72 billion was pulled from market in October The Tennessean, TN - Dec 24, 2008 By ES Browning • THE WALL STREET JOURNAL • December 24, 2008 One of the hallmarks of the long market downturns in the 1930s and the 1970s has returned: ...

Valparaiso University law school to provide tax help nwitimes.com, IN - Jan 5, 2009 Taxpayers with annual income of $42000 or less are eligible for the help if they have not received income from the sale of stocks, mutual funds or homes or ...

New Money features for you USA Today - Dec 15, 2008 They include: •Year-to-date returns for stocks, mutual funds and exchange-traded funds (ETFs). These can be found by entering the name or ticker symbol in ...

Like other stocks, mutual funds show heavy losses during 2008 LubbockOnline.com, TX - Dec 27, 2008 By Tim Paradis | AP NEW YORK - There was one safe bet that mutual fund investors could make in 2008 - that the stock market was a place to lose a lot of ...

High school investments team wins game Greenwich Post, CT - Jan 4, 2009 The Greenwich High School investment course is more akin to a college-level course covering stocks, mutual funds, bonds and other securities. ...

Be wary of US treasury bonds in 2009 Stockhouse, Canada - Jan 5, 2009 They pulled money out of stocks, mutual funds, money market accounts, even bank savings accounts and CD’s, and poured it into US T-bills and bonds at a ...

Value? Growth? Both! Motley Fool - Jan 2, 2009 The distinction between value and growth stocks is such a bedrock assumption that Morningstar routinely classifies stocks, mutual funds, and ETFs as one or ...

City pension funds may cost taxpayers Allentown Morning Call, PA - Jan 4, 2009 ... the crumbling economy has pummeled Allentown's pension funds, which rely on stocks, mutual funds, real estate and other investment tools for growth. ...

A better bailout alternative American Thinker, WA - Dec 18, 2008 Any type of funds may be used: CDs, bonds, stocks, mutual funds, cash, money market funds. - IRA owners can contribute any percentage of their qualified ...