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Earnings: The Indispensable Element Of Great Stocks

Watching For Pitfalls

Investors can easily be misled by popular myths about earnings.

  • Myth: You should buy stocks with low price-to-earnings (P-E) ratios.

The P-E ratio is a comparison of the stock's price to its annual earnings per share. For example, a stock quoted at $50 a share with annual earnings of $5 per share has a P-E ratio of 10. In other words, the stock is selling at 10 times its annual earnings.

Conventional wisdom says stocks with higher P-E ratios are overpriced and should be avoided. But the truth is that the best stocks often have high — some would say ridiculous — P-E ratios when they start their big climbs. And they continue having high P-Es throughout their advances.

Studies prove the percentage gain in earnings per share over the year-earlier period had a greater impact on a stock's price.

Would you have purchased these "high" P/E stocks?

Stock   P/E Ratio before advance
Amgen   300  (Up 650% in 22 months starting March 1990)
America Online   205 (Up 557% in six months starting October 1998)
Mindspring   157 (Up 237% in five months starting November 1998)
Ascend Communications   49 (Up 1,380% in 15 months starting August 1994)
MCI Communications   42 (Up 266% in 17 months starting April 1988)

If you weren't willing to pay the higher P-Es, you eliminated some of the best stocks of all time.

  • Myth: It's better to get into an unprofitable company's stock before the company turns around and other investors discover it.

Again, studies tell you established companies that can't make much money for themselves can't make much money for investors. Even in late 1990s, when it seemed any stock with a dot-com name could surge without the slightest hint of profitability, a track record of good earnings growth still won the day. Research has shown most Internet stocks with earnings growth outperformed their counterparts posting losses.

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