This chapter is from the book
This chapter is from the book
This chapter is from the book
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Given the high returns that low PE ratio stocks earn, should you rush out and buy such stocks? While such a portfolio may include a number of undervalued companies, it may also contain other less desirable companies for several reasons. First, not all earnings are of equal quality. In recent years, some firms have used accounting sleight of hand and one-time income to report higher earnings. You would expect these firms to trade at lower price-earnings ratios than other firms. Second, even if the earnings are not skewed by accounting choices, the earnings can be volatile and the low PE ratio may reflect this higher risk associated with investing in a stock. Third, a low PE ratio can also indicate that a firm's growth prospects have run out. Consequently, it could be a poor investment.
Table 3.4. Stocks with PE Ratios Less Than 10: United States—October 2002
Risk and PE Ratios
In the earlier section, you compared the returns of stocks with low price-earnings ratios to other stocks in the market over a long period and concluded that low PE stocks do earn higher returns on average. It is possible, however, that these stocks are riskier than average and that the extra return is just fair compensation for the additional risk. The simplest measure of risk you could consider is stock price volatility, measured with a standard deviation in stock prices over a prior period. Consider the portfolio of low PE stocks that you constructed at the end of the last section. The standard deviation in stock prices was computed for each stock in the portfolio. In Figure 3.7, the average standard deviation for the low PE portfolio is compared with the standard deviation of all stocks in the market for a three-year and a five-year period.
)
Figure 3.7. Standard Deviation in Stock Prices
Surprisingly, the lowest PE stocks, are, on average, less volatile than the highest PE stocks, though some stocks in the low PE portfolio are more volatile than average.
Some studies try to control for risk by estimating excess returns that adjust for risk. To do so, though, they have to use a risk-and-return model, which measures the risk in investments and evaluates their expected returns, given the measured risk. For instance, some researchers have used the capital asset pricing model and estimated the betas of low PE and high PE portfolios. They come to the same conclusion that the analyses that do not adjust for risk come to: that low PE ratio stocks earn much higher returns, after adjusting for beta risk, than do high PE ratio stocks. Consequently, the beta was computed for each of the stocks in the low PE portfolio, and the average was contrasted for the portfolio with the average for all other stocks, as shown in Figure 3.8.
)
Figure 3.8. Betas of Low PE Ratio Companies
On this measure of risk as well, the low PE ratio portfolio fares well, with the average beta of low PE stocks being lower than the average PE for the rest of the market.
While the average beta and standard deviation of the low PE portfolio is lower than the average for the rest of the market, it is still prudent to screen stocks in the portfolio for risk. You could, for instance, eliminate all firms that would fall in the top quintile of listed stocks in terms of risk, beta or standard deviation. Looking at stocks listed in October 2002, this would have yielded cutoff values of 1.25 for beta and 80% for standard deviation. Removing firms with betas greater than 1.25 or standard deviations that exceed 80% from the sample reduces the number of stocks in the portfolio from 115 to 91. Table 3.5 lists the 24 firms removed as a result of failing the risk screen.
Table 3.5. Firms Removed from Low PE Portfolio: Risk Test
|
COMPANY NAME |
INDUSTRY |
BETA |
STANDARD DEVIATION |
|---|---|---|---|
|
Beverly Enterprises |
Medserv |
1.27 |
75.58% |
|
Allmerica Financial |
Insprpty |
1.31 |
49.50% |
|
Precision Castparts |
Defense |
1.33 |
52.58% |
|
Federated Dept Stores |
Retail |
1.34 |
46.00% |
|
Telefonos de Mexico ADR |
Telefgn |
1.4 |
43.74% |
|
Petroleum Geo ADR |
Oilfield |
1.4 |
74.49% |
|
Shaw Group |
Metalfab |
1.44 |
69.20% |
|
United Rentals |
Machine |
1.68 |
58.13% |
|
Flowserve Corp |
Machine |
1.71 |
54.84% |
|
InterTAN Inc |
Retailsp |
1.73 |
61.29% |
|
Dynegy Inc 'A' |
Gasdivrs |
1.78 |
77.24% |
|
Tyco Int'l Ltd |
Diversif |
1.87 |
60.57% |
|
Stillwater Mining |
Goldsilv |
1.87 |
65.61% |
|
Salton Inc |
Houseprd |
2.05 |
73.57% |
|
CryoLife Inc |
Medsuppl |
−0.34 |
81.08% |
|
Dura Automotive 'A' |
Auto-oem |
2.35 |
81.56% |
|
Quanta Services |
Indusrv |
2.48 |
82.67% |
|
Calpine Corp |
Power |
1.95 |
85.18% |
|
Metro One Telecom |
Indusrv |
1.74 |
86.70% |
|
AES Corp |
Power |
2.26 |
89.64% |
|
Aftermarket Tech |
Auto-oem |
1.02 |
100.83% |
|
ePlus Inc |
Internet |
1.57 |
113.77% |
|
Westpoint Stevens |
Textile |
0.74 |
126.22% |
|
Acclaim Entertainment |
Ent tech |
3.33 |
237.57% |
Note that firms are required to pass both risk tests. Thus, firms that have betas less than 1.25 (such as Westpoint Stevens) but standard deviations greater than 80% are eliminated from the portfolio.
Low Growth and PE Ratios
One reason for a low PE ratio for a stock would be low expected growth. Many low PE ratio companies are in mature businesses for which the potential for growth is minimal. If you invest in stocks with low PE ratios, you run the risk of holding stocks with anemic or even negative growth rates. As an investor, therefore, you have to consider whether the tradeoff of a lower PE ratio for lower growth works in your favor.
As with risk, growth can be measured in many ways. You could look at growth in earnings over the last few quarters or years, but that would be backward looking. There are stocks whose earnings have stagnated over the last few years that may be ripe for high growth, just as there are stocks whose earnings have gone up sharply in the last few years that have little or no expected growth in the future. It is to avoid this peering into the past that investors often prefer to focus on expected growth in earnings in the future. Estimates of this growth rate are available for different forecast periods from analysts and are often averaged and summarized (across analysts) by services such as I/B/E/S or Zacks. The average past and expected growth rates in earnings per share for firms in the low PE portfolio are computed and compared in Figure 3.9 to the same statistics for the rest of the market in October 2002.
)
Figure 3.9. Growth Rates: Lowest PE Stocks vs. Other Stocks
The earnings of the lowest PE ratio stocks have grown faster than the earnings of other stocks if you look back in time (one year or five years). However, the projected growth in both sales and earnings is much lower for the low PE ratio stocks, indicating that this may be a potential problem with the portfolio and a partial explanation for why these stocks trade at lower values. Consequently, you should consider screening the portfolio of low PE stocks for those with low or negative growth rates. Introducing a minimum expected growth rate of 10% in expected earnings reduces the sample of low PE stocks by 52 firms. A minimum expected growth rate of 5% would reduce the sample by 27 firms. If you believe that analyst estimates tend to be too optimistic and introduce an additional constraint that historical growth in earnings would also have to exceed 5%, you would lose another 18 firms from the sample. Table 3.6 summarizes the 41 firms that are eliminated by introduction of a dual growth constraint—a historical earnings per share growth rate that exceeds 5% and analyst projected earnings per share growth greater than 5%.
Table 3.6. Firms Removed from Low PE Portfolio: Growth Test
|
COMPANY NAME |
TICKER SYMBOL |
PROJECTED EPS GROWTH |
EPS GROWTH—LAST 5 YEARS |
|---|---|---|---|
|
REMOVED BECAUSE PROJECTED GROWTH LESS THAN OR EQUAL TO 5% |
|||
|
Aquila Inc |
ILA |
–10.00% |
7.00% |
|
CMS Energy Corp |
CMS |
–4.00% |
–0.50% |
|
PNM Resources |
PNM |
–1.50% |
11.50% |
|
UIL Holdings |
UIL |
–1.00% |
4.00% |
|
Trans World Entertain |
TWMC |
–0.50% |
0.00% |
|
Stillwater Mining |
SWC |
0.50% |
0.00% |
|
Allegheny Energy |
AYE |
1.00% |
8.50% |
|
Allmerica Financial |
AFC |
1.00% |
11.50% |
|
Marathon Oil Corp |
MRO |
1.00% |
28.00% |
|
Imperial Chem ADR |
ICI |
1.50% |
–3.50% |
|
Pinnacle West Capital |
PNW |
2.00% |
9.00% |
|
El Paso Electric |
EE |
2.50% |
15.50% |
|
Salton Inc |
SFP |
2.50% |
72.50% |
|
Calpine Corp |
CPN |
3.50% |
0.00% |
|
Sprint Corp |
FON |
3.50% |
0.00% |
|
Ashland Inc |
ASH |
3.50% |
14.50% |
|
Universal Corp |
UVV |
3.50% |
15.50% |
|
Westpoint Stevens |
WXS |
4.00% |
0.00% |
|
ENDESA ADR |
ELE |
4.00% |
1.00% |
|
Quanta Services |
PWR |
4.50% |
0.00% |
|
TECO Energy |
TE |
4.50% |
4.50% |
|
Lafarge No. America |
LAF |
4.50% |
17.50% |
|
Del Monte Foods |
DLM |
5.00% |
0.00% |
|
May Dept. Stores |
MAY |
5.00% |
6.00% |
|
Tommy Hilfiger |
TOM |
5.00% |
15.00% |
|
Precision Castparts |
PCP |
5.00% |
20.50% |
|
AES Corp |
AES |
5.00% |
28.50% |
|
REMOVED BECAUSE HISTORICAL GROWTH LESS THAN OR EQUAL TO 5% |
|||
|
Westar Energy |
WR |
16.00% |
–25.50% |
|
Green Mountain Pwr |
GMP |
20.50% |
–19.50% |
|
Petroleum Geo ADR |
PGO |
15.00% |
–14.50% |
|
Beverly Enterprises |
BEV |
9.50% |
–12.50% |
|
Gerber Scientific |
GRB |
14.00% |
–9.50% |
|
Quaker Fabric |
QFAB |
18.17% |
–5.50% |
|
Sola Int'l |
SOL |
6.00% |
–3.50% |
|
Nash Finch Co |
NAFC |
17.50% |
-–3.50% |
|
Aftermarket Tech |
ATAC |
8.50% |
2.00% |
|
TXU Corp |
TXU |
9.50% |
2.00% |
|
Electronic Data Sys |
EDS |
13.00% |
2.50% |
|
Chromcraft Revington |
CRC |
13.00% |
4.00% |
|
Gadzooks Inc |
GADZ |
18.33% |
5.00% |
Earnings Quality and PE Ratios
With their focus on earnings per share, PE ratios put you at the mercy of the accountants who measure these earnings. If you assumed that accountants make mistakes but that they work within established accounting standards to estimate earnings without bias, you would be able to use PE ratios without qualms. In the aftermath of the accounting scandals of recent years, you could argue that accounting earnings are susceptible to manipulation. If earnings are high not because of a firm's operating efficiency but because of one-time items such as gains from divestiture or questionable items such as income from pension funds, you should discount these earnings more (leading to lower PE ratios).
How can you screen stocks to eliminate those with questionable earnings? It is difficult to do, since you learn of troubles after they occur. You could, however, look for clues that have historically accompanied earnings manipulation. One would be frequent earnings restatements by firms, especially when such restatements disproportionately reduce earnings.[7] Another would be the repeated use of one-time charges to reduce earnings. For example, Xerox had large one-time charges that reduced or eliminated earnings every single financial year during the 1990s. A third is a disconnect between revenue growth and earnings growth. While it is entirely possible for firms to report high earnings growth when revenue growth is low for a year or two, it is difficult to see how any firms can continue to grow earnings 20% a year, year after year, if their revenues growth is only 5% a year.