The price to earnings ratio or PE is a simple concept. Merely divide the stock price by the annual earnings to arrive at the PE ratio. If the stock is trading at $10 per share and the annual profit is $2 per share, then the price to earnings ratio is 5. But are price to earnings ratios still practical in today’s market?
Why Warren Buffett Uses Price to Earnings Ratios
Value investors such as Warren Buffett look for solid stocks trading below fair value. These are hearty companies usually in a boring or lackluster industry that is overlooked. At some point, as profits continue to roll in at a steady pace, investors take note and the stock climbs.
Picking neglected value stocks requires more effort than merely looking at PE ratios. One value screening setup can be read here. Why do value investors often look for low price to earnings ratios?
Low PE Ratios Could Mean Future Growth.
The book Buffetology, written by Mary Buffett and David Clark, makes a direct link between growth rates and PE ratios. For instance, if a stock is trading at $10 per share and earns $2 per share each year, the value of the stock theoretically increases by 20% in 12 months. Practice is different than theory, but one can see how profit relates to growth. In five years’ time the stock should double in value. If the earnings are increasing over time as can be seen by comparing future PE to current PE ratios, the price should rise quicker yet again.
Value investors could run into trouble if price to earnings ratios were too high. If a stock was trading at $100 per share and only earned $1 per share in 12 months, then the intrinsic growth rate is only 1%. Even if the stock earned $2 the next year, thus experiencing 100% increase in growth rates, the intrinsic growth is still only 2% of the share price. If the growth rate tapers off the stock could be in for a nasty retreat.
William J. O’Neil and Price to Earnings Ratios
Inventor of the high growth CAN SLIM trading methodology, William J. O’Neil asserts that PE ratios can largely be ignored. He claims that low PE ratios are at the bottom of the dumpster because the stock is only worth that much according to public opinion. A high PE ratio is worth its lofty price tag. He looks for high growth ratios with increasing or accelerating growth along with other metrics. Once the price forms a specific patterns such as the cup and handle he buys shares.
William J. O’Neil’s ideology is much different than Warren Buffett’s. William J. O’Neil is not necessarily a long term investor. He chooses to buy stocks that will rocket in bull markets, but then sells after three or four consolidation periods that could lead to a crash. These high growth stocks with large PE ratios are often the quickest droppers in bear markets.
Which method is better? That really depends on the type of investor one is. If they like to own a stock for life, Warren Buffett is the man to follow. If the person is a trader that flips volatile stock depending on the market cycle, then William J. O’Neil will provide more short term action.
Caveats of Price to Earnings Ratios
While finding a low price to earnings ratio is a start, it is definitely not the final word in value investing. Another criteria related to PE that investors should look for is high earnings per share. A stock might be trading with a PE of 5. Upon inspection the annual earnings might only be 1 cent per share per year with a share price of 5 cents. Risk goes up with penny stocks with companies that are earning very low net profits. The low PE stock might be shares in the lemonade stand outside the front door.
Stable price to earnings ratios are also important. A company might have an exceptional year and a low PE but this could be because investors know that revenue is about to dump pulling down earnings with it.
Lastly, stocks in trouble such as ones being sued, rejected by the FDA, or about to experience a huge negative fundamental change might have a deceivingly low PE ratio. Still, using low annual profit to price screening can give investors a good starting point when picking cheap value stocks that may rise over time.
One Method of Finding Cheap Undervalued Stocks Using PE Ratios:
- High annual earnings (possibly over $1.00 per share)
- Stable earnings per share over past 3 to 5 years
- Future PE higher than trailing PE
- Low price to earnings ratio equaling 10 or less