Using the P/E Ratio to Evaluate Stocks

Case Background:
Three private equity firms have joined together in a $10B deal to purchase the supply division of Home Depot Inc. The sale price was lower than analysts and investors had expected. The company offered no comment on its decision, but it is thought that the move is designed to appeal to shareholders looking for positive action.

Discussion:
It seems that recent troubles in the housing market are to blame for the less-than-expected price of the sale. It is because of this, in fact, that Home Depot has backed away from diversifying into supply, instead choosing to return to the basics of retailing.

Conclusion:
Some have speculated that Home Depot's future expansion may not rival its past growth. However, the future is still unwritten, and the company appears to be solid. Its P/E ratio currently stands at 14.48. This and other available information should be used before making a decision.

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.