If there is one number that the whole world looks at closely while evaluating stocks and the overall market, it is the Price to Earning Ratio (P/E). P/E is the prism to judge whether stock price is high or low. If the market P/E is around 20, it is supposed to be expensive and if it’s 12, it is supposed to be cheap. But how reliable is this ratio for predicting future returns?
P/E measures the number of times a stock quotes as a multiple of its earnings per share and is also commonly referred to as the P/E multiple. It is simply the number of times the market is willing to pay for one rupee of the company’s earnings. A high P/E signifies high expectations of investors from the company. Investors have already caught on to the company’s earnings growth story and today’s prices reflect that. A low P/E signifies that investors have low expecta-tions from the stock. Since the market acts to fool the largest number of people the maximum number of times, a high P/E stock is supposed to lead to disappointment. The logic is that since a high P/E already incorporates investors’ expectations and the stock has already been bought by a larger number of investors during its run up, there are fewer investors left to buy and even a slight disappointment can send it skidding.
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