except for some brief periods of extreme undervaluation and
overvaluation. However, it is common to find companies trading with P/
E's below and above this level, because companies that are growing
earnings at a fast rate often have higher P/E ratios than companies
that are not.
Since 1900 the average P/E of a stock has been 14. Normally when a
stock has a P/E less than 10 either it is extremely undervalued or
else the company's earnings are in decline. Between 10 and 17 is
considered a normal valuation. While stocks with a P/E between 17 and
25 are either overvalued or else the company's earnings are growing
fast enough to justify the larger valuation. Once you get to stocks
with P/E's over 25 you are looking at stocks that are richly valued
and have become fads.
A preferred strategy is to use the forward P/E and PEG ratio to figure
out the potential for growth stocks you own or may buy over the next
year. The forward P/E divides the price by next year's annual earnings
estimates to get an idea of how much potential a stock has to rise
over the next year. Make it a point to look for a forward P/E less
than 10 to find a bargain growth stock and consider the 14 area as my
target valuation. So, if a stock has a forward P/E of 7, you can
consider it as having the potential to double in price over the next
12 months based on earnings growth.
Of course it can go up more than that if enough investors get excited
about it, which happens a lot in bull markets with growth stocks, but
once a stock you own goes from having a small bargain forward P/E to
reaching the 14 level you can consider it fairly valued from a
valuation standpoint.
Famous investors Peter Lynch and John Templeton used the PEG ratio to
do a similar type of analysis. The PEG ratio divides the P/E by the
expected earnings growth rate for the next five years. Both considered
growth stocks to be fully valued at a PEG ratio of 1.0 and stocks
below that to have the potential to move higher, with the lower the
ratio the better.
Templeton, for instance, would look to buy stocks with PEG ratios
below 0.50. If a stock has a forward P/E of 14 and a low PEG ratio,
this is because analysts are projecting high earnings growth for years
out. Such a stock may still be cheaply valued.
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