Prices Beyond Reason

On its own, each P/E ratio is meaningless. The P/E points us to optimism or pessimism, which we must then find the reasons for. For example, a massively high P/E is sometimes the result of a rumored takeover. Or it may reflect an industry in tatters, where the share price is yet being supported by small shareholders reluctant to face reality and retaining their holdings in the hope of better times. It may equally reflect confidence in a new product that’s set to be a blockbuster. Whatever the story behind a variation from a normal share valuation, you, as an investor, should know about it. Above all, the underlying reasons for current levels of optimism (or pessimism) are critical in determining whether such valuations are likely to persist.

So, remember, no one P/E ratio has a fixed meaning (good or bad). There is no cutoff for what is high or low. There is, however, normal and abnormal. So, get familiar with the normal. Then you can use the abnormal to get straight to the places where share prices are most definitely moving out of step.