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Applying PE Tests

PE ratio, the third of the three primary indicators, can signal a number of important overall trends. These include:

  1. Changes in overall market perception about a stock. As PE rises or falls, we can track what that means in terms of how investors view a particular stock. Because PE is a snapshot in time, analysis is only useful when done in comparative form. So, year-end comparisons between market price and EPS are most reliable, especially when tracked from year to year. This approach coordinates the timing of each side of the ratio (as opposed to the more popular technique of comparing current price to outdated EPS). It also compares like periods, which is most important when analyzing cyclical stocks (for example, Sears and other retailers will exhibit vast differences in operations between the fourth calendar quarter and the following first calendar quarter).

  2. Impact of core earnings adjustments. You will discover that a comparative PE often appears quite erratic and consequently difficult to use for confirmation of other trends. However, core earnings adjustments often have a significant impact on erratic PE and may smooth out the results on a post-core-earnings basis. This works to indicate the significance of core earnings adjustments (a fundamental adjustment) and its effect on market price (the technical side). The changes that core earnings adjustments make in many cases further confirm the theory that price volatility is, at least in part, a reflection of the difference between reported earnings and core earnings.

  3. Confirmation of strength or weakness in other indicators. As you review core PE (the PE ratio after core earnings adjustments), you can confirm what you discover elsewhere in the financial information published by the company. For example, in this chapter we introduced a three-year analysis of Sears to demonstrate how core earnings adjustments affect reported profits; how that adjustment helps us to discover other important trends; and how the process confirms what we see initially in sales, earnings, and EPS. When we add an analysis of the PE ratio, we gain some idea of market perceptions about the stock, both on the basis of reported results and after core earnings adjustments.


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