Ask Colin

I fail to see any relationship between the PE ratio and the performance of a share. How can it help a trader make better decisions?

It will not be as much help to a trader. However, for an investor, there is very persuasive statistical evidence that a low PE ratio is a good marker of undervaluation that often leads to good uptrends.

For a good summary of the evidence, see David Dreman Contrarian Investment Strategies - The Next Generation. Also the work of James O'Shaughnessy.

The basic reason is simple commonsense - if you can buy a company for 10 times its earnings, it has a better chance of going up than where you pay 20 times its earnings. The exception to this is when the company has excellent growth prospects, when it can justify a higher ratio, because the E will grow very fast. However, the PE ratio for a growth company can also be too high and all the growth for many years is already discounted in the price with no room for mishaps along the way. These are price accidents waiting to happen. So, if you have a company growing at 20%pa with a PE ratio near 20, I would buy it, but if it had a PE ratio near 40 or 50, I would not touch it. Buying it at that price is greater fool theory territory.

You mention good trends in Sonic Health Care with a PE ratio near 50 and CSL with a PE ratio near 70. These are out of my league because they are too expensive on those numbers. To justify them, you need to forecast high sustained growth. There is no room for mishaps and they have to be those mythical trees that grow to the sky. Both are, I think, coming off bad years, so historical PE ratios may not be very relevant. Still they are a bit rich for me at this stage. Then again maybe I am only a conservative survivor and I am wrong because the greater fool theory really works and I have missed huge opportunities. Maybe it will be different this time. But I won't be betting on it.

Keyword: