InvestorQ : What is the P/E trap in valuation and how can I avoid that?
Ria Jain made post

What is the P/E trap in valuation and how can I avoid that?

Answer
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2 years ago


Price Earnings (P/E) ratio is one of the most popular ways of valuing a stock. The thumb rule is that a low P/E ratio is a sign of undervaluation while a high P/E ratio is a sign of overvaluation. But such an approach of purely using P/E Ratio to Value a stock is fraught with risks. The question, therefore, is How to Avoid the P/E Trap?
What exactly is the P/E trap and How to Avoid the P/E Trap? There are 3 traps to avoid. Firstly, there is the growth trap to avoid. A high growth company may not only enjoy a higher P/E but also justify it. On the other hand, a low P/E stock may not necessarily be a sign of an underpriced stock. Secondly, Low P/E ratios may be the market’s way of signaling that something is either wrong with the company in question or with the industry as a whole. It is essential not to miss out on this signal. Lastly, P/E used to value a stock is normally forward P/E and such forward P/Es are based on estimated earnings. Therefore, there is too much emphasis being laid on the sanctity of cash flow projections, which may not necessarily reflect a precise understanding of how the industry and the company are evolving. The key question, therefore, is “How to avoid the P/E Trap”?