Ask Colin

What PE ratios do you see as unreasonable for value and growth stocks?

The answer for value stocks is easier than for growth stocks.

Value stocks: In my newsletter No 30 on www.bwts.com.au I explain how I determine a reasonable PE ratio for a value stock by using a risk premium over the bond rate. This is useful as a guideline for filtering a large data base for potential value stocks. However, it is just that - a guideline.

In general terms, the lower the PE ratio the better, providing it is based on a profit that is realistically maintainable. I would then give preference to a stock below the above guideline, all other things being equal (they rarely are as often as economists seem to assume). From there upwards it is a matter of judgement, but I am reluctant to go above the market average PE ratio. However, there are as many exceptions as there are rules. I don't think that investing can be reduced to a rule-based regime in this area because there are too many variables. I am very strong on rules for money management and trade management - that is critical. But stock selection is not really that important. Most people only focus on stock selection. I give it less thought than the areas that really determine my results.

Growth stocks: How long is a piece of string? Seriously, it is almost impossible to set a rule. In general terms, I like the idea of the PEG ratio (see www.bwts.com.au Ask Colin page). However, I hate to say so because people rush off and say Colin said this stock was OK because its PEG ratio was 0.9 or some other figure. I cringe. This is so superficial.

The PE ratio must be seen in relation to the market average PE ratio, which will in turn be related to the bond yield by a long rubber band. If I can buy a growth stock near the market average PE, I first look really carefully at why it is so cheap. If I can satisfy myself as to its growth prospects and it is trending up, then OK. But I need to be convinced and it must be trending up. If it isn't then someone knows something I don't know. Even if they are wrong, I can afford to wait until that becomes obvious on the chart.

It is more likely that a growth stock will have a PE ratio higher than the Market average. This is where the basic idea of the PEG ratio comes in. The PE ratio must be reasonable in terms of the demonstrated past growth in earnings per share.

Don't worry about forecast earnings per share. No matter who makes the forecast. That is the are where fools and the charlatans operate. Nobody can predict earnings consistently - especially the management or analysts whose firm may have loads of the stock to sell or whose firm sponsored the listing of the company.

So, if a company has been growing at 25%, then a PE ratio of 20 to 25 times earnings is good. You may have to pay a bit more in most cases. But if the PE ratio is 50 times, or 60 times or even more, you are probably in what my friend Dr Elder calls greater fool territory - see his book Come into my Trading Room.

Remember that to justify a 90 times PE ratio, like Computershare had at its top, the company is going to need to take over every firm in its industry in the next ten or twenty years to justify that price. It is not going to happen. And nobody can be certain that far in the future.

Over and above these comments, with growth stocks, I don't think the PE ratio is that important. I buy uptrends as early as I can. I will enter an established trend if the PE ratio is still reasonable (20 to 30 times for the company I suggested above), but not if the PE ratio is already silly. With growth stocks it is the uptrend that is 90% of the decision on entry and exit. The rest is the stuff the beginners agonise about and miss the trends I buy. Sad, but true. Again it is about them having primary focus&n

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