The P/E Ratio equals the price of a stock divided by the earnings. The higher the P/E ratio is, the more growth the company has seen or is expected to have. But this is also an indication that the company is overvalued and things could be about to turn around. A low P/E can signal a good time to buy, but it can also mean that the company is having problems. The P/E ratio can be very helpful in assessing stocks but it needs to be considered along with other important factors.

The P/E chart of a company or index over time can tell us a lot about how risky the investment is or if it’s a good time to buy in. When considered with future earnings, forecasts can be made on the future price of the company. At Market Flavor we tend to prefer stocks that have relatively low P/E ratios compared to a long term P/E chart. This shows us that the stock is trading at a relatively cheap price level and if we can justify growth in the company then we know it’s a good stock to invest in. However, sometimes there is nothing wrong with a company that has a relatively high P/E. A high P/E is OK when the company is growing rapidly and is going to continue to grow at an even faster rate. If they aren’t growing, or growing might slow, you should wait until the P/E comes down before buying. It’s also good to compare the P/E ratio of a company to that of its competitors. This can often be an apple to orange comparison but at least you can see how close they are and how their P/E charts compare.

P/E ratios contract and expand over time. This can be caused by the economy or earnings expectations. When you buy a stock that has a high P/E, like a tech company, you run the risk of the P/E contracting to fall back in line over time. Say earnings go up 20% but the P/E pulls back 20%, due to lower earning forecasts, you are left with a stock that didn’t go anywhere. So make sure to look at the P/E ratio of the company and a P/E chart to compare and consider the P/E trend. Also consider forward earnings and the strength of the company to decide if the P/E might expand or contract.

Here is a link to an advanced chart at Big Charts. You will need to expand the time period and also add P/E ratio as a lower indicator.

This link shows a price chart and P/E chart of the S&P 500. We are at very low P/E levels, which indicates we could see a BIG rally within the next year or so.

Read more about P/E Ratios at Investopedia.