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Notice: The following is provided for informational purposes only and does not constitute investment advice. Please do your own independent research before making any investment descision. You are responsible for the choices you make and this is just some stuff you read about on the web. The price/earnings (P/E) ratio of a stock is the best measure of a stock's expectations. Imagine a stock trading at a P/E of 100. That means that for every 100 dollars you invest in it, your company earns just one dollar a year. That's a return on your investment of a measly one per cent. The only way to justify such a paltry return on your investment is the optimistic belief that the earnings will increase over time and the returns on your investment will rise. As was pointed out before, stocks with high expectations underperform. High P/E stocks will underperform over the long run. Conversely, stocks with low P/E's represent the unpopular stocks that have so much upside potential. Will all low P/E stocks make you money? No! Referring to the News/Expectations matrix on the previous page, we see that the price of low P/E stocks often stays flat and may even lose money. However, their downside risk is much lower than high P/E stocks. Other indications of an undervalued stock include a low price/cash flow ratio or a low price/book value ratio. When selecting stocks within the low P/E universe, look for the following characterics. They will help you choose the stocks with the greatest potential for appreciation.
Now when you investigate the companies that have the above characteristics, you will find many of them have truly frightening prospects. Some of them will indeed go bankrupt and the stock become worthless. So, once you have identified the pool of low P/E stocks, you will want to take a look at a few of each company's fundamentals to identify those companies with the best opportuntity to turn themselves around. Here are some additional ratios to examine:
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