Why is the price/earnings ratio a common and popular technique for eva

Why is the price/earnings ratio a common and popular technique for evaluating stocks? Why do fast growing firms have higher P/E ratios? What is a long-run average P/E ratio for larger publicly traded firms in the United States?

What are some limitations to using this technique to evaluate stock prices?

ANSWER

P/E ratios are common because the reasoning is intuitive, appealing, and the calculation is easy to make. The P/E implies information about the risk, timing, and magnitude of future cash flows. The long-run average P/E for U.S. stocks is about 16. Thus, for every current dollar of earnings, (or expected earnings in the next period) we pay around $16. If a firm is expecting earnings next year of $5 per share we might be willing to pay in the neighborhood of (16 * $5 ) $80 per share. Faster growing firms that will provide larger cash flows earlier than slower growing firms have higher P/Es. Riskier firms with more uncertain cash flows earn lower P/Es. Of course, this is the problem with P/E ratios, they are simply rules of thumb based on historical information and created without serious fundamental investigation. Still, P/Es serve as a useful first pass in evaluating equity values.