Price to earnings (PE) ratio is the first thing one learns when it comes to the stock market. Most stock P market books, almost all the stock market courses and majority of curriculum related to stock market emphasise on understanding the PE ratio and attempt to simplify reading the complex stock market with a simple PE ratio. On the ground too, the use of PE ratio amongst investors is commonplace.
Market commentators use PE readings to narrate market conditions almost on a daily basis and that is partly the reason why investors tend to give so much importance to the PE multiple. It is the combination of being intuitively appealing and the huge acceptance of PE ratio along with the simplicity of calculation that makes it such an attractive matrix to read market valuations and thereby gauge the mood of the market.
Defining the PE Ratio
The PE ratio simply tells us a lot about the market's current view on companies' earnings. Simply put, the PE ratio compares a company's stock price with its earnings per share and helps determine if it is fairly priced. Higher PE ratio often leads investors to conclude that a stock could be overvalued and a lower PE leads investors to believe that the stock is undervalued. However, it may not always be true. What do PE ratios don't tell you? PE ratio helps us understand if a particular stock is fairly valued. There are various ways to estimate from the current PE if the stock is fairly valued. One of the most popular ways is to estimate if the current PE is trading higher than its long-term average.
One can safely suggest that if the current PE is way higher than the long-term average, the stock could be overvalued and vice-versa. One must remain cautious during times when the PE is wandering way above the long-term average PE multiple.
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