Arc Price-Earnings Ratios Important?

Now that we've discussed the indispensable importance of a stock's current quarterly earnings record and annual earnings increases in the last five years, you may be wondering about a stock's price-to-earnings (P/E) ratio. How important is it in selecting stocks? Prepare yourself for a bubble-bursting surprise.

P/E ratios have been used for years by analysts as their basic measurement tool in deciding if a stock is undervalued (has a low P/E) and should be bought or is overvalued (has a high P/E) and should be sold.

Factual analysis of each cycle's winning stocks shows that P/E ratios have very little to do with whether a stock should be bought or not. A stock's P/E ratio is not normally an important cause of the most successful stock moves.

Our model book studies proved the percentage increase in earnings per share was substantially more crucial than the P/E ratio as a cause of impressive stock performance. During the 33 years from 1953 through 1985 the average P/E for the
best performing stocks at their early emerging stage was 20 (the Dow Jones Industrial's P/E at the same time averaged 15). While advancing, these stocks expanded their P/Es to approximately 45 (125% expansion of P/E ratio).