Using the P/E Ratio to Evaluate Stocks

Case Background:
Sallie Mae has been the world's largest originator of student loans for some time. However, there have been some problems with school officials referring students toward specific lenders. Nevertheless, this has not stopped J.C. Flowers and the firm of Friedman, Fleischer, and Lowe to buy them out in a $25 billion deal.

Discussion:
After the buyout (which was at $60 per share) was announced, Sallie Mae stocks increased 18 percent. Top management has indicated that there will be no difference in the way student loans are processed. One concern, though, is that there may be increased regulation from lawmakers--a potential problem for this industry. The investors who purchased Sallie Mae are not overly concerned
about this, however, as the stock price and potential for the company seemed irresistible.

Conclusion:
Sallie Mae's P/E ratio currently stands at 21.07. This ratio, as well as other relevant financial information, should be taken into account before making a decision to purchase stock in this (or any) company.

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.