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How investors use P/E ratio
PE ratios are often used in Fundamental Analysis, which is a method for analyzing and evaluating a company’s stock. Investors seek out companies with high P/E Ratios that are sometimes called growth stocks.
While growth stocks can provide considerable capital appreciation if the company experiences the expected growth by investors, leading to an increase in the share price, they can also be:
- Quite volatile and a risky investment.
- Overvalued due to the stock's price being high relative to earnings.
- The high P/E Ratio may simply be a result of having a large amount of investment capital.
On the other hand, companies with low P/E Ratios are known as value stocks. Value stocks are considered by investors as stocks currently being sold at a discount. However, they can be:
- Undervalued as their stock prices trade lower relative to fundamentals.
- In a slow growth phase due to market conditions.
If a company is newly listed or has not yet reported earnings, the P/E Ratio may be indicated as N/A which means that the ratio is not available or not applicable to the company's stock. It could also mean that the company has zero or negative earnings.
The P/E Ratio works best when comparing companies within the same sector.