The calculation is formulated as:
So, what does it means to the novice investors? Briefly, if a company were currently trading at a multiple (P/E) of 50, the basic interpretation is that an investor is willing to pay $10 for $0.20 of current company earnings. So, it appears the investors are buying/holding stocks at a high premium.
So, why there are still many investors willing to go for high P/E stocks knowing there are an upside risk? Mainly, Stocks with "high" P/E ratios share a common trait: their performance shows there's plenty of bullishness about the company's future sales growth prospects and outstanding earnings. This usually further 'boost' the company's share especially when market is in the bull run since most investors are optimistic about the market at that time. Nothing wrong for being optimistic but one have to be realistic to the stock market world, stock markets are full of uncertainties ahead. How many of us foreseen the sub-prime problems when market 'seems to be doing fine'?
Past experience has shown us that those who held high P/E stocks usually got their fingers 'burnt' badly when the unexpected got them. The situation get even worse when investors bought high P/E penny stocks or stocks without strong fundamental.
Unless investors can stomach the pains of these 'sudden turn', otherwise, I think it is important to focus on stocks with low P/E ratio with good fundamental. Although P/E ratio is only one of the factors that investors should consider when buying shares, it usually has also less downside risk when market is heading south or running against you. So generally speaking, it's better to be safe than sorry.
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