Using the P/E Ratio to Evaluate Stocks

Case Background:
Netflix stock has done very well. At its IPO in 2002, it started at $8 per share (split-adjusted). By the fourth quarter of 2003, it had enjoyed exponential growth. In fact, its upward trend has been consistent for years. The company's idea of having movies available online, and being able to order and return movies by mail, has been a very popular strategy that has led to enormous success for Netflix. However, any great idea is likely to bring competition, which has certainly been the case as Blockbuster and others have entered the picture.

Discussion:
True, Netflix stock has been performing well. But at what point should the astute investor discern indications that it's time to sell? There are, in fact, many signs that stock-savvy shareholders have noted, which indicate that it may be time to move on. These include several declines which, when charted, show a trough.

Conclusion:
The P/E ratio of Netflix currently stands at 29.65. This information, combined with what is noted above, may lead one to conclude that now is a good time to sell. However, it's important to take everything into account. Some would still say that the company, which has shown good performance and perseverance, will rebound from its current setbacks.

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.