Reaching into the mailbag this week, I found this reader question:
“Could you please explain PE ratios? After a recent purchase, I discovered the listed PE to be much higher than expected. My broker responded that the forward PE was in normal range and “don’t look in the rear view mirror.” Thank you for your help.”
Usually people are not alone in their desire to know things, so I decided to share the answer here.
If you divide a company’s stock price by its earnings per share, you’ll come up with a price/earnings ratio, or PE. This simple number reflects how well thought-of the stock is by investors. A single-digit PE is generally considered to be low, while a number over 20 is generally considered to be high. If stocks were commodities, like bananas, a low price/earnings ratio would represent a bargain–a good value.
But at Cabot, a high PE does not keep us from buying a strong growth stock because, unlike commodities, when you buy a stock you are betting that earnings will grow in the future. And a high PE simply confirms that other investors believe your company will experience fast earnings growth in the future.
I hope that helps! More questions and answers can be found throughout our Web site and some are grouped on a new page called “Ask the Editor,” which you can access here.