How Price-Earnings Ratios Are Misused

Many Wall Street analysts inspect the historical high and low price-earnings ratios of a stock and feel intoxicating magic in the air when a security sells in the low end of its historical P/E range. Stocks are frequently recommended by researchers when this occurs, or when the price starts to drop, because then the P/E declines and the stock appears to be a bargain.

Much of this kind of analysis is based on questionable personal opinions or theories handed down through the years by academicians and some analysts. Many "green" newcomers to the stock market use the faulty method of selecting stock investments based chiefly 011 low P/E ratios and go wrong more often than not.

This system of analysis often ignores far more basic trends. For example, the general market may have topped out, in which case all stocks are headed lower and it is ridiculous to say "Electronic Gizmo" is undervalued because it was 22 times earnings and can now be bought for 15 times earnings. The market break of 1987 hurt many value buyers.