Price to earning ratio of any stock is simple calculated by dividing the current price of the stock by the total earnings per stock after tax and other liabilities are taken into account. PE ratio is an indicator of investor sentiment regarding a company's future prospects. Usually, a high PE Ratio depicts a faster growing company and investor confidence in such company is high. However, while comparing two companies in the same sector with similar capital base and earnings, a higher PE ratio would indicate an overvalued stock.
PE ratio can be used very effectively while picking stocks. The basic idea is to catch a stock before it gets overvalued (high PE ratio) and thereby has a tendency to reverse and fall back. This can be acheived by looking at historical data for a stock and calculating and average PE ratio. If the stock is below or close to the average and market conditions are favourable, then it would be a good strategy to buy into such a stock.
Sunday, March 1, 2009
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