PE ratio

An interviewer asked me what PE ratio is, i was able to give the formula: MPS/EPS and a simple reply: " it means how much investor are willing to pay for the company’s net earning per share" The next question he posted " So is high PE ratio better or low PE ratio better because i have heard that low PE could be an indication the stock is cheap relative to the industry average?" My reply: ----I just stared at him …lol Can anyone help to solve this question?

or a relative basis a low P/e is better. it means the stock is undervalued in relation to similar companies in the industry.

but a low PE could also mean the company is poor investment, hence the lower stock price so the interviewer was most likely trying to pull a CFA trick by leading to unclear answer that requires you to really know what the ratio and other pert info is telling you.

A higher P/E suggests a better company, but not necessarily a better investment. The investment can only be assessed relatively, using other info such as expected growth, peer comparisons, etc, etc. From an investment perspective a lower or higher P/E than the average tells us nothing in isolation.

Rule of thumb is low PE relative to industry is a better investment as you expect PE to approach the mean and thus gain from price increase. However it is also possible for the company to never increase in price (happens a lot with mid caps). Another thing to consider when assessing PE ratio is to use normalised earnings, because reported earnings could appear high and hence PE low because of using below the line items in net income, so analyst adjustment is almost always required to get normalisd PE. PEG ratio in conjunction with PE is also a good measure (Low PEG preferred over high), a low PE with low growth can give you high PEG compared to high PE with high growth, because the high growth can transalte to high earnings in the future leading to low PE, just judging investment on PE only can give you a skewed picture. I also agree that there is no “ONE” right answer here your thought process and rationale behind reaching your conclusion is what really matters.

answer is ‘go f*** yourself’ I would’ve said no because you can’t make an investment based on one ratio alone. You will get screwed. Relative valuation requires you to value several ratios in tandem and make a decision based on that… (something along these lines…)

Well, using a little bit of intuition, low P/E is either because price is low or earnings is high…both good…thus you would want to buy. A naive question deserves a naive answer. However, tying the P/E ratio to expected growth is really what needs to be done to answer the question, and probably what the interviewer wants you to do. Every P/E implies a growth rate. Low P/E could imply low expected growth which could be good or bad depending on your investment objectives. The easiest way to see this is through the growing annuity (gordon growth) equation: P = E / (r-g) I don’t like PEG…it has its own flaws…but analyzed together with P/E could provide additional, useful information. Ratios are just tools, naive tools. Naive reliance on ratios will lead to failure. That is why people hire analysts anyway, to analyze this information and draw better conclusions than the ratio provides in isolation.

Thank you all, now I know how to deal with question like tis

Low P/E ratio = Value stocks High P/E ratio = Growth stocks