I am new to investing. I understand that the P/E ratio along with other data can be used to determine whether a stock may or may not be undervalued.

Are there situations where a HIGH P/E is actually beneficial? Say for instance you have a stock with a P/E of 20. If the earnings-per-share on that stock increases by $1, you would expect that if the P/E ratio remains constant then the price of the stock would increase by $20. It is somewhat counter-intuitive that a high P/E would be desirable, but it stands to reason that if the market is willing to pay 20x earnings when earnings are at X, why wouldn't the market be willing to pay 20x earnings (or perhaps even more) when earnings move to X + 1.

I think I read something along these lines in Burton Malkiel's book but I am not positive, any thoughts on this concept or research in that area I could look into? What considerations can we make with respect to whether its reasonable to assume that the P/E ratio will remain constant, increase, or decrease?


closed as off topic by Ram Ahluwalia, quant_dev, Derek Ploor, Steve Severance, Bob Jansen Jan 7 '12 at 12:07

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  • $\begingroup$ I am curious why SE doesn't have place for professional research analyst yet? Even the new proposal, "Stock Investing", doesn't look like for professional fundamental research analyst or portfolio manager. The sample questions look more like for proprietary traders. As for Money.SE? I have to say it's more for amateur. Also, the topic there is too diverse. $\endgroup$ – 楊祝昇 Jan 7 '12 at 4:56
  • $\begingroup$ If there is a SE for fundamentals research analyst, this is definitely a nice classical question! :) Sean, I wish I could answer your somewhere. What a pity that we don't have a place for you yet. $\endgroup$ – 楊祝昇 Jan 7 '12 at 5:01
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    $\begingroup$ Professional fundamental analysis of a quantitative nature would be very welcome. This is a basic PE question, much more suitable for a personal finance site. $\endgroup$ – Steve Severance Jan 7 '12 at 7:12
  • $\begingroup$ @楊祝昇 I wouldn't really consider this question "professional", it may be welcome on money.SE, as it is a personal investing question. Sean, let me turn the question around. Why would the market be willing to pay 20x EPS after earnings rise? If b/c the move was unexpected, then of course the stock will rise. If the move was actually less than expected, the P/E will likely drop quite a bit. The point is that P/Es are unstable, and high P/Es certainly aren't beneficial by themselves. $\endgroup$ – Tal Fishman Jan 8 '12 at 0:37
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    $\begingroup$ @楊祝昇 Perhaps some day there will be, but at the moment there doesn't seem to be much demand, only 20 followers for Investment Banking (note: this proposal is really more about professionals working at investment banks than banking per se). $\endgroup$ – Tal Fishman Jan 9 '12 at 19:36