Using the P/E Ratio to Evaluate Stocks

Case Background:
Best Buy has been able to capitalize on a key component of retail success--customer service--which has vaulted it ahead of competitors such as Circuit City, Costco, and Fry's. This has translated to a fourth quarter-gain of 18 percent.

Discussion:
The attention to customer needs is noticeable from the time one enters a Best Buy store. A friendly greeting is followed by a knowledgeable sales associate offering assistance. If the assistance is declined, the sales rep will not become pushy.

This stands in contrast to other stores, where it is sometimes the case that employees are either unavailable, lacking in knowledge, or not well-trained. Customer loyalty is huge in the retail industry, and Best Buy's increasing profit demonstrates this.

Conclusion:
Best Buy's current P/E ratio is 19.04, compared to 22.86 for Circuit City, one of its main competitors. In light of its focus on customer service, with earnings to back up the value of this, it may be a good time to invest.

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.