I just read an ebook about How To Make Money in Stock BY Willian J. O Neil.. In this entry, I’ll share some point about Price Earnings Ratios. So let’s read it
Are Price-Earnings Ratios Important?
Now that we’ve discussed the indispensable importance of a stock’s current quarterly earnings record and annual earnings increases in the last five years, you may be wondering about a stock’s price-to-earnings (P/E) ratio.
How important is it in selecting stocks? Prepare yourself for a bubble-bursting surprise. P/E ratios have been used for years by analysts as their basic measurement tool in deciding if a stock is undervalued (has a low P/E) and should be bought or is overvalued (has a high P/E) and should be sold.
Factual analysis of each cycle’s winning stocks shows that P/E ratios have very little to do with whether a stock should be bought or not. A stock’s P/E ratio is not normally an important cause of the most successful stock moves.
Our model book studies proved the percentage increase in earnings per share was substantially more crucial than the P/E ratio as a cause of impressive stock performance.
During the 33 years from 1953 through 1985 the average P/E for the best performing stocks at their early emerging stage was 20 (the DowJones Industrial’s P/E at the same time averaged 15). While advancing, these stocks expanded their P/Es to approximately 45 (125% expansion of P/E ratio).
Why You Missed Some Fabulous Stocks!
While these figures are merely averages, they do strongly imply that if you were not willing to pay an average of 20 to 30 times earnings for growth stocks in the 40 years through 1993, you automatically eliminated most of the best investments available!
P/Es were higher on average from 1953 to 1970 and lower between 1970 and 1982. From 1974 through 1982, the average beginning P/E was 15 and expanded to 31 at the stock’s top. P/Es of winning stocks during this period tended to be only slightly higher than the general market’s P/E at the beginning of a stock’s price advance.
High P/Es were found to occur because of bull markets. With the exception of cyclical stocks, low P/Es generally occurred because of bear markets. Some OTC growth stocks may also display lower P/Es if the stocks are not yet widely owned by institutional investors.
Don’t buy a stock solely because the P/E ratio looks cheap. There usually are good reasons why it is cheap, and there is no golden rule in the marketplace that a stock which sells at eight or ten times earnings cannot eventually sell at four or five times earnings. Many years ago, when I was first beginning to study the market, I bought Northrop at four times earnings and in disbelief watched the outfit decline to two times earnings.
How Price-Earnings Ratios Are Misused
Many Wall Street analysts inspect the historical high and low price-earnings ratios of a stock and feel intoxicating magic in the air when a security sells in the low end of its historical P/E range. Stocks are frequently recommended by researchers when this occurs, or when the price starts to drop, because then the P/E declines and the stock appears to be a bargain.Much of this kind of analysis is based on questionable personal opinions or theories handed down through the years by academicians and some analysts. Many “green” newcomers to the stock market use the
A = Annual Earnings Increases 19
faulty method of selecting stock investments based chiefly on low P/E ratios and go wrong more often than not.
This system of analysis often ignores far more basic trends. For example, the general market may have topped out, in which case all stocks are headed lower and it is ridiculous to say “Electronic Gizmo” is undervalued because it was 22 times earnings and can now be bought for 15 times earnings. The market break of 1987 hurt many value buyer .
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