What is the P/E Ratio and what does it mean?

The underlying idea behind the P/E is that a high P/E means high projected earnings in the future. In actuality the P/E ratio doesn't tell us a whole lot, but it's useful to compare the P/E ratios of other companies in the same industry, or to the market in general, or against the company's own historical P/E ratio.

The idea behind the P/E Ratio is that it is a prediction or more likely an expectation of the company's performance in the future. A company with a P/E higher than the market or industry average means the market is expecting big things over the next few months or years. A company with a high P/E ratio will eventually have to live up to this high rating by either substantially increasing its earnings, or the stock price will need to drop.

A good example is Microsoft, several years ago when Microsoft was flexing its monopolistic muscles and growing by leaps and bounds its P/E ratio was over 100. Today Microsoft is still one of the largest companies in the World, but revenues are growing at a slower percentage rate. The result is a P/E ratio of 41 (Aug. 2000). This reduction in the P/E ratio is a usual occurrence as companies solidify themselves as blue chips.

Don't buy just because of the P/E Ratio

If there is one thing that you get from this tutorial it should be that a company with a low P/E ratio does not necessarily mean that it is undervalued. The P/E does not dictate the stock price, in fact a low P/E could mean that the company's earnings are flat or declining. A low P/E could also mean that they are in financial trouble, the market thinks that the company could be out of business in the short future.

Although we mentioned before it's worth saying again. The P/E Ratio doesn't tell us a whole lot, but it's useful to compare the P/E Ratios of other companies in the same industry, or to the market in general, or against the company's own historical P/E Ratios.

Two major factors that can affect a stocks price no matter how low the P/E ratio is how good the economic conditions are and the unpredictable emotions of investors:

Never Short Sell stocks with high P/E's

Those of us who work hard for our money don't need to take unnecessary risks. One risk that we recommend no one take is to short sell a stock with a high P/E ratio - otherwise know as a high flying stock.

As you already have read, a high P/E ratio typically means that the stock is high growth. The major characteristic of high growth stocks is that their stock prices rise at a higher than average rate. Short selling a stock with this characteristic is arguably the riskiest position to be in.

In December of '99 a company you may have heard of called Qualcomm was trading at almost $200 and a P/E ratio over 100. At this P/E many investors felt that it was extremely overvalued. In the proceeding month the stock nearly doubled once more...a very costly mistake by those who did decide to short sell.