The P/E method
Various mechanical solutions to this problem have been suggested. For example, selling growth stocks when their P/E reaches twice the market average. Historically, this has tended to mark the top of their price range. The bottom is usually reached when their P/E is roughly equal to the market average.
Following this rule would certainly have saved you from some serious falls in share prices. Unfortunately, it would also have made you sell the best growth stocks in history, when it would clearly have been better to hold them.
Example
Microsoft's P/E remained above 50 for many years after its flotation in 1986, but that did not stop the shares rising fiftyfold in 10 years.
The PEG method
Another mechanical method gets round this problem by using the PEG. This is a more three-dimensional measure, because it relates the P/E to the growth rate. Thus a stock with a P/E of 50 remains a hold, provided earnings are forecast to grow at, say, 60%.
The American creators of the Motley Fool website suggest taking profits once the PEG has risen to 1.0. Jim Slater proposes a more aggressive figure of 1.2. Nearly every commentator agrees there are unacceptable risks in holding stocks on PEGs of 1.5 or above.
Once again, the rule limits your risks, but also some of the potential rewards. Coca-Cola looked overvalued on this basis for much of the Sixties. But its subsequent growth rate turned out to be much higher than expected. In retrospect, an even higher rating would have been justified.
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