The Wrong Way to Analyze Companies in an Industry

Tags: Stocks, Stock Market Guide, Stock tips, Stock Techiniques

Another common, poor use of price-earnings ratios by both amateurs and professionals alike is to evaluate the stocks in an industry and conclude that the one selling at the cheapest P/E is always undervalued and is therefore, the most attractive purchase. This is usually the company with the most ghastly earnings record, and that's precisely why it sells at the lowest P/E.

The simple truth is that stocks at any one time usually sell near their current value. So the stock which sells at 20 times earnings is there for one set of reasons, and the stock that trades for 15 times earnings is there for other reasons the market already has analyzed. The one selling for seven times is at seven times because its overall record is more deficient. Everything sells for about what it is worth at the time.

If a company's price level and price-earnings ratio changes in the near future, it is because conditions, events, psychology, and earnings continue to improve or suddenly start to deteriorate as the weeks and months pass.

Eventually a stock's P/E will reach its ultimate high point, but this normally is because the general market averages are peaking and starting an important decline, or the stock definitely is beginning to lose its earnings growth.

High P/E stocks can be more volatile, particularly if they are in the high-tech area. The price of a high P/E stock can also get temporarily ahead of itself, but so can the price of low P/E stocks.