Using the P/E Ratio to Evaluate Stocks

Case Background:
Motorola is about to acquire Terayon Communication System, Inc. for something like $140 million. Upon this purchase, Motorola will pay cash for all of Terayon's common stock, at $1.80 per share.

Discussion:
Terayon is a manufacturer of video processing products, which, by optimizing bandwidth, allow viewers access to content of regional or local interest. The acquisition of this company will give Motorola various digital ad insertion and channel-optimizing technologies.

Conclusion:
Motorola's P/E ratio currently stands at 12.32. This, along with considerations such as Motorola's current market position and other financial data, should be taken into account before deciding whether to buy or sell Motorola stock.

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.