How Can I Predict the Future PE of a Stock


Ask SmallIvy

Dear SmallIvy,

How can I predict the future PE of a stock?

Keep up the good work,

H.Prince

 

Dear Mr. Prince,

The Price to Earnings ratio, or PE, is not something that can be predicted directly; however, like the price of a can of soda will be around a certain price most places, the PE will generally stay within the same range for a given stock.  Just like in retail, however, there are times it will be very high (like buying anything at a movie theater) and there are times when it very low (like when a store has a sale).  Fortunately with stocks you also have the ability to sell some shares when the prices are high (wish I could do that at a movie theater).

One strategy , called value investing, is to find stock that are trading near the low-end of their normal PE range.  When the PE is low, just as with the soda, you first need to check and see if there is a catch.  Often the PE is low for a reason.  If there is not, you should try to buy shares when you find the PE of a stock with good prospects is low.  The range of PEs for a given stock will depend on 1) its industry, since stocks in the same industry tend to trade at similar PE multiples, 2)its place in the industry – the leaders will trade at higher PEs than the lessor competitors, and 3) the rate of earnings growth and/or dividend yield – how much the stock is expected to return.  

The last factor is probably the most important.  When evaluating the price of a stock against its peers, just because it is above the average does not mean it is overpriced.  If it is growing market share and has a good earnings growth rate it should be higher in price.  Compare the current PE with past value to see if the stock is pricey or cheap.  Be wary, however, because if earnings growth slows the PE ratio will also drop since the stock no longer deserves the premium then.

Comments appreciated! What are your thoughts? Questions?

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