Gauging stock value using P/E ratios
Price-earnings ratio, or P/E, is one of popular tools for investors to value stocks or stock indices, whether theirprices are cheap, expensive, or fairly valued. Long-term, value investors use the P/E ratio to get indication whetherstocks are cheap enough to make them start buying. The following graph shows the S&P 500 10-year price/earnings ratios based on Yale economist Robert Shiller's(Irrational Exuberance) stock valuation metric for a period starting from 1926 up to August 2009. The P/E medianover the 82 years is 16.2, while the ratio stood at 18.9 at the end of August 2009. The record overvaluation of 44.2happened in Dec. 1999. This simple gauge focuses on fundamental measures, which are earnings. In its basic form, the P/E ratio iscalculated by dividing a stock's price (or the value of an index) by its annual earnings. Before using the ratio, investors have to understand the P/E ratios and how reliable they are to gauge stock value.
A high P/E can be a sign that a stock is either overvalued or poised for stellar growth.A low P/E can be a sign of a stock that is a good long-term value or a sign of a company in trouble.If earnings hold steady, falling prices should make stocks more attractive to long-term investors. The P/E will fallaccordingly. But that's not necessarily true if earnings fall faster than prices do. In this case, the P/E will increase.