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Chapter 2. Trend Discovery: Finding the ... > Balancing PE and Market Perceptions:...

Balancing PE and Market Perceptions: Looking to the Future

In using PE ratio as a primary test, we can also learn a lot about how the market generally perceives a stock's value. There is a general sense that higher PE means higher growth potential. In practice, however, PE ratios higher than average have historically underperformed market averages, and stocks with lower than average PE have performed better than market averages. Many investors would assume just the opposite.[1]

The purpose of using PE as one of our analytical tools is to try to get some idea of the company's growth direction and rate. The comparison between current price and a series of quarter-ending earnings is also aggravated by the fact that quarterly reports often do not reflect adjustments that should be made. A full audit at year-end may reveal substantial timing differences, income recognition problems, and other accounting decisions that distort interim reports. We need the audited year-end numbers to establish long-term trends and to make an attempt to look to the future. At the same time, we have to recognize the limitations of PE as a reliable indicator. It is useful to confirm other information about both price and financial values; but using the PE to attempt a calculation of future growth is too far removed from the reliable information we need to make informed decisions.


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