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Why PE ratio is important for Stock market Investors?

PE Ratio is one of the most important ratios for value investors. It is a measure which helps investors to measure the dollars needed to buy a stock as compared to its  dollar earnings.Value investors like warren buffet give special importance to the PE ratio.His investment history tells that he always tries to buy stocks with very low PE ratio.Following are the most important benefits of  PE ratio for the stock market investors.

  • Price earnings ratio plays an important role in devising serious investing strategy.Most of the people fail to understand and utilize this tool in most effective way. Proper utilization of this tool can significantly increase the risk and stock returns.

  • Many successful investors around the world rely on the PE ratio for buying or selling a particular stock.They give special importance to this metric. These types of stock traders are always in search of stocks which have PE ratios equal or lower than  company’s earnings per share growth rate. They believe that a company with a strong growth has more value in the stock market than the company with a slow growth rate.These investors have a very good knowledge of improving their returns by properly making use of their knowledge about the PE ratio and different valuation techniques.

  • Most of the stock experts agree on this point that stocks with low PE ratios have better long term earning potential than the stocks with high PE ratios.So this means that this is one of the metrics which help value investors and devising their long term investing strategies.
  • Stock market analysts believe that stocks with low PE ratios have very high earning yields.Stock with high earning yields have good chance to return back high returns to the investors in the long run.
  • Value investors use this ratio to identify overvalued and under priced stocks in the stock market.A formula or ratio can be developed by integrating  earning growth and PE ratio. This formula gives a clear and comprehensive picture of the overall stock health and value.  This ratio is popularly known as PEG ratio and can be calculated  as follows:

PEG Ratio = P E ratio/Annual EPS growth

The lower PEG ratio represents  that stock of the company is undervalued and higher than usual PEG ratio shows that a overvalued stock in the stock market.

It is true that PE ratio is a very useful measure for investors but we cant take it a s absolute measure. Various industries have different average PE ratios .So we can compare PE ratios  different companies in same industry with the industry average of the PE ratio.Value investors must research for long term risks before making any stock investment decision.

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About Emaad Qureshi