P/E ratios, do they really have any predictive value?Some traders believe that the P/E ratio (Price to Earnings) of a company can be used to make good trading decisions.
This ratio basically measures how "cheap" ("undervalued") a company's stock price is by comparing its earnings-per-share (EPS) to its current stock price.
The generally accepted idea is that stocks with a "low" P/E ratio are "good", while those with a high P/E ratio are "bad" and should not be bought.
Nothing could be further from the truth, for many reasons!
The first one is that a company facing financial difficulties (not known to the public yet) or in serious trouble can still have a "low" P/E and attract tons of unsuspecting investors/traders.
On the other hand a "high" P/E ratio could simply mean that the company is GROWING (its stock price and EPS are rising at the same time).
Famous trader and author William J. O'Neill did a study on these P/E ratios and later concluded, in his now famous "How to make money in stocks" book : "Contrary to most investors' beliefs, P/E ratios were not a relevant factor in price movement".
Take Advanced Micro Devices Inc. (Nasdaq symbol AMD) for instance, the stock I talked about recently.
In September 2023 its P/E ratio was 856.83, an "insane" P/E ratio for most traders.
And yet AMD proceeded to more than double in price less than 6 months later, see for yourself (chart above, blue line)!
Ok, I am NOT saying that P/E ratios are meaningless and should be discarded, just be warned that they are virtually worthless if you try to use them to predict future price movements in the stock market, ESPECIALLY in the short term.
Happy trading fellow traders, and stay on the right side of the market.
