Tracking your great stock's price-earnings ratio can help you spot a previously unexpected spot to unload amid a frenzy of buying. Why and how
Savvy growth-stock investors tend to shrug off price-to-earnings (P-E) ratios. If they're too low, they wonder what's wrong with the stock. And if they're too high — well, there's almost no such thing, especially when the market is trending up.
P-E ratios are rarely calm when a growth stock is soaring. They tend to swell as the clamor grows for those shares.
Typically, you can expect a stock's P-E ratio to climb 130% after that stock has started its bull run. IBD research has found that many great market winners experience such expansion from the initial to its peak.
So, what can you do
Let's say you bought XYZ Corp. at 100.10, and the P-E ratio was 20. The stock flies. It builds a second base. It breaks out again. Probably you've been adding shares strategically as the stock puts in its big move.
Let's flash forward a bit, maybe a few months, maybe a few years. The stock is trading at 300, and shows no sell signs. But the P-E ratio has surged to 46. Well, so what? A hot stock can support much higher valuations. But 46 is a 130% rise from 20, which is where the P-E ratio was when the stock first broke out.
You needn't unload as soon as the P-E ratio hits 46. But if you multiply that 46 P-E by the full-year earnings estimate at the time of the breakout, you come up with a target price in which it may be time to get ready to sell.
Your sell-signal radar should be tweaked to heightened alert. Is it going on a climax run? Is dwindling as the stock strikes ? Is the big winner suddenly moving sideways in choppy fashion? Are funds starting to feed their shares into the market
Maybe you'd be disposed to suffer a sell signal or even two. After all, you have huge gains in this stock.
But given the large P-E expansion, you now need to lower your threshold of tolerance. Your price target also should be in range by this time.
The accompanying table shows several current leaders, their P-E ratios at the breakout, and a potential value for the expanded P-E and target price.
Of course there's no shortage of moving parts to this application, so stay alert. But you have to be alert anyway.