Why is using the P/E ratio a very popular valuation tool?
What will be an ideal response?
Answer: Many investors use the P/E ratio because it helps to compare the stock's growth potential relative to other firms. When you purchase a stock, you are not really buying the company as it stands today. You are actually buying the earnings potential in the future. A healthy, well run company will have innovative products and growing market share leading to growing EPS. It is the EPS in the future that you are actually buying today. The P/E ratio communicates how the market feels about the future prospects of the firm.
The P/E ratio also communicates a level of risk. When a stock is 'priced to perfection' with a high P/E ratio, then the firm had better live up to these lofty expectations for future growth. Any bad news such as disappointing earnings growth or slowing sales growth or competitive or regulatory pressures can cause these stocks to plummet in value to match the new, reduced expectations for earnings growth.
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