Using the P/E Ratio to Evaluate Stocks

Case Background:
DaimlerChrysler hasn't been doing as well as its shareholders might have expected. Amid recent problems with its US operations, GM has placed a bid to buy the struggling auto giant. Another potential buyer, Magna International, Inc. (of Canada), along with an unnamed partner, has shown an interest. This latter possibility led to DaimlerChrysler stock reaching a 52-week high on Friday.

Discussion:
It seems unlikely that GM's offer will be accepted, as it has been considered too low. Other offers may be more plausible, but there is no certainty about whether DaimlerChrysler will end up being sold at all. One significant problem the automaker faces is the $19 billion obligation to pay long-term healthcare benefits to retired union workers. Should this figure be larger than its assets, DaimlerChrysler may have to sell.

Conclusion:
The company's value is currently estimated at being between $0 and $13.7 billion. With such uncertainty, it is hard to make a decision about what to do with DaimlerChrysler stock at this time. The P/E ratio of 19.38 is only one of many factors that should be considered.

Disclaimer:
P/E ratios are a quick way to sort out the leaders within the same sector. Never use a P/E ratio exclusively to make an investment. Remember, a P/E ratio is measured using historical trailing earnings for the previous 12 months and does not necessarily indicate strong future earnings. P/E ratios, when used with other market value ratios, can help investors to make consistent returns and to minimize losses. Various interpretations of a particular P/E ratio
are possible:

0-13 - Either the stock is undervalued or the company's earnings are thought to be in decline.
14-20 - For many companies, a P/E ratio in this range may be considered fair value.
- The average U.S. equity P/E ratio is usually around 14, which means it takes about 14 years for a company's stock to earn back its full purchase price.
- Average P/E over the entire market is a good indicator of overall market strength.
21-28 - Either the stock is overvalued or the company's earnings have increased since the last earnings figure was published.
28+ - A company whose shares have a very high P/E ratio either really does have an exceptionally rosy future or the stock may be the subject of a speculative bubble.
A company with no earnings has an undefined P/E ratio.