The PE ratio tells you if a stock is overpriced when it is compared to its earnings. It is suppose to be a good indicator for weather a stock is undervalued or overvalued. By why does it work?

1. You want to invest in strong earnings

Obviously the more money a company is making the better an investment the company is in the long term. No one wants to invest in a company that isn’t making money. But everyone wants to invest in Coke or Google or any other large company making a ton of sales.

2. Prices act irrational

If the stock market always acted rational then there would not be any bulls markets or bears markets. Instead the markets would be flat and every time some news would come out about a company that company would adjust instantly. Because the markets don’t work this way prices fly all over the place. The PE ratio gives you a way to measure when the market has overreacted.

3. Dividends and growth

One side affect of looking at a company’s earnings is that a company’s earnings will influence how much dividend they can afford to pay. A company with high earnings can afford to give a much higher dividend to it’s shareholders then a company with low earnings. Earnings can also affect the growth of a company. As a company earns money they can reinvest it in themselves to grow even faster.

4. Everyone Looks At it

PE is one of the most looked at financial ratio when deciding if a company is a good buy or not. And the benefit of this is that in the stock market when everyone looks at something it becomes much more accurate.

If 30 million people are looking at something to decide if it is a great buy or sell it is going to have a lot more influence on the price of the stock then if 3 people are looking at it.

For more on the PE ratio and other fundamental ratios visit http://www.stocks-simplified.com/fundamental_analysis.html

Author's Bio: 

When I was young I wanted to learn how to trade the stock market. So I traveled around the country listening to professional traders talk about how they are making money in the market. Now I understand how easy it is to make money in the stock market and started a site stocks-simplified.com to help others learn.