With this knowledge I am sure you will be able to arm yourself with a secret weapon with which you can make a lot of money on the stock market. That is in fact the goal of any beginner to make tons and loads of money from the stock market like Warren Buffet and retire on a beach with that money.

If you need an absolute theoretical definition of the P/E ratio then you can read about the stock market term P/E ratio and earnings per share here in this post of mine.

Measure to check how expensive the stock is?

The higher the p/e ratio the more someone is willing to pay to acquire the stock and that means that you are actually trying to buy an expensive that also means that the stock may be risky because the expectations from that stock are high and in case the future earnings of that stock are not met then you will may as well as lose money on that stock.

The stocks with low P/E ratio will actually be called defensive as the earnings expectations are less on a year basis and that means that you will have to be much more proficient in selecting a particular stock.

P/E ratio of An Industry

Most of the time the p/e ratio of  the companies in a given industry is compared to make sure that you are not comparing apples to oranges but only oranges to oranges.

P/E ratios and history

The P/E ration of a an industry can be different than the p/e ratio of  another industry  and say the p/e ratio  of technology can be 100 whereas the P/E ratio of consumer goods may be only 10. Does that mean that you cannot have the stock of consumer goods? No that is wrong but the truth that in general technology stocks mat give you good growth but also on the downside the risk is more should the technology stocks fall as a whole.

 You can compare the P/E ratio from historical perspective and then come to a conclusion whether the industry you are trying to invest is more risky that the others or not .

P/e Ratio of the Index

The P/E ratio of Dow or S&P 500 or the NASDQ 100 is an important tool in giving you a historical perspective on the overall health of the market as well as the health of the economy in general.

There are no companies which publish the P/E ratio of an index but you can get that information in round about manner and that is called the exchange traded fund. There are exchange traded funds which closely track the index be it the DJIA or the S&P 500 and hence the P/E ratio of these can give you a fairly close method of evaluation the P/E ratio.

On the Dow Jones website also there is the P/E ratio of the Dow Jones Industrial Average and that is for example at 13.34 as of Nov 28^th, 2008.

P/E ratio versus the P/B ratio and how to use them

A Price to book ratio is a good barometer on how to use the price to book value as an indicator of how the stock market for beginners will pan out in future.

A  P/B ratio in general means that you will be able to get maximum out of the two major things on the stock markets which are

Market capitalization

And

Book value of equity which is equal to the book value of assets minus the book value of liabilities is the best way to get the describe the book value of equity.

Low P/B ratio means that the stock is destroying assets or shareholder value because of the fact that anything under 1.0 means that the assets are being grossly underutilized

  Return On Equity  

Return on equity is what is very similar to Book value of equity. The return on equity of a company means net income divided by the shareholders equity and that is know as the RONW or the return on net worth equity.

Then there is ROCE or return on common equity which means that Net income – dividends/common equity.

 Understanding the ROE or return on equity is very important as gives us important message in terms of how the company is doing on three fronts the profit margin as well as the financial leverage as well as how well the company is employing the assets to gain profitability.  

Related posts:

1. P/b ratio definition and p/b ratio explained in simple terms
2. Stock Market Terms – EPS and P/E ratio
3. Explain NASDAQ for beginners