Home > Articles > Business & Management > Finance & Investing

This Stock Is So Cheap! The Low Price-Earnings Story

Are price-earnings ratios are good indicators of value? Will a strategy of buying stocks with low price-earnings ratios generate high returns? Learn why a stock that trades at a low PE is not always cheap, and the long term can be a long time coming.
This chapter is from the book

Graham's Disciple

Jeremy was a value investor, and he had disdain for investors who chased growth stocks and paid exorbitant prices for them. Reading Forbes one day, Jeremy was excited to see the results of an academic study that showed that you could beat the market by buying stocks with low price-earnings ratios, an approach highly favored by other value investors. Getting on Yahoo! Finance, Jeremy looked for stocks that traded at price-earnings ratios less than 8 (a number he had heard on CNBC was a good rule of thumb to use for low PE stocks) and was surprised to find dozens. Not having the money to invest in all of them, he picked the first 20 stocks and bought them.

In the year after his investments, instead of the steady stream of great returns that the academic study had promised, Jeremy found himself badly trailing the market. All his friends who had bought technology stocks were doing much better than he, and they mocked him. Taking a closer look at his depleted portfolio, Jeremy found that instead of the safe, solid companies that he had expected to hold, many of his companies were small risky companies with wide swings in earnings. He also discovered that the stocks he picked were unusually prone to reporting accounting irregularities and scandals. Disillusioned, Jeremy decided that value investing was not all it was made out to be and shifted all of his money into a high growth mutual fund.

Moral: A stock that trades at a low PE is not always cheap, and the long term can be a long time coming.

For decades investors have used price-earnings ratios (PEs) as a measure of how expensive or cheap a stock is. A stock that trades at a low multiple of earnings is often characterized as cheap, and investment advisors and analysts have developed rules of thumb over time. Some analysts use absolute measures—for instance, stocks that trade at less than 8 times earnings are considered cheap—whereas other analysts use relative measures, for example, stocks that trade at less than half the price-earnings ratio of the market are cheap. In some cases, the comparison is to the market, and in other cases it is to the sector in which the firm operates.

In this chapter, you consider whether price-earnings ratios are good indicators of value and whether a strategy of buying stocks with low price-earnings ratios generates high returns. As you will see, a stock with a low price-earnings ratio may not be undervalued and strategies that focus on just price-earnings ratios may fail because they ignore the growth potential and risk in a firm. A firm that trades at a low price-earnings ratio because it has little or no prospects for growth in the future and is exposed to a great deal of risk is not a bargain.

Core of the Story

How do you determine that a stock is cheap? You could look at the price of a stock; but stock prices can be easily altered by changing the number of shares outstanding. You can halve your stock price (roughly) with a two-for-one stock split (by which you double the number of shares), but the stock does not get any cheaper. While some investors may fall for the pitch that a stock that trades for pennies is cheap, most investors are wary enough to see the trap. Dividing the price by the earnings is one way of leveling the playing field so that high-priced and low-priced stocks can be compared. The use of low PE ratios in investment strategies is widespread, and several justifications are offered for the practice:

  • Value investors buy low PE stocks. Investors in the value investing school have historically measured value by using the price-earnings ratio. Thus, when comparing across stocks, value investors view a stock that trades at five times earnings as cheaper than one that trades at ten times earnings.

  • A low PE stock is an attractive alternative to investing in bonds. For those investors who prefer to compare what they make on stocks to what they can make on bonds, there is another reason for looking for stocks with low price-earnings ratios. The earnings yield (which is the inverse of the price-earnings ratio, that is, the earnings per share divided by the current stock price) on these stocks is usually high relative to the yield on bonds. To illustrate, a stock with a PE ratio of 8 has an earnings yield of 12.5%, which may provide an attractive alternative to treasury bonds yielding only 4%.

  • Stocks that trade at low PE ratios relative to their peer group must be mispriced. Since price-earnings ratios vary across sectors, with stocks in some sectors consistently trading at lower PE ratios than stocks in other sectors, you could judge the value of a stock by comparing its PE ratio to the average PE ratio of stocks in the sector in which the firm operates. Thus, a technology stock that trades at 15 times earnings may be considered cheap because the average PE ratio for technology stocks is 22, whereas an electric utility that trades at 10 times earnings can be viewed as expensive because the average PE ratio for utilities is only 7.

InformIT Promotional Mailings & Special Offers

I would like to receive exclusive offers and hear about products from InformIT and its family of brands. I can unsubscribe at any time.


Pearson Education, Inc., 221 River Street, Hoboken, New Jersey 07030, (Pearson) presents this site to provide information about products and services that can be purchased through this site.

This privacy notice provides an overview of our commitment to privacy and describes how we collect, protect, use and share personal information collected through this site. Please note that other Pearson websites and online products and services have their own separate privacy policies.

Collection and Use of Information

To conduct business and deliver products and services, Pearson collects and uses personal information in several ways in connection with this site, including:

Questions and Inquiries

For inquiries and questions, we collect the inquiry or question, together with name, contact details (email address, phone number and mailing address) and any other additional information voluntarily submitted to us through a Contact Us form or an email. We use this information to address the inquiry and respond to the question.

Online Store

For orders and purchases placed through our online store on this site, we collect order details, name, institution name and address (if applicable), email address, phone number, shipping and billing addresses, credit/debit card information, shipping options and any instructions. We use this information to complete transactions, fulfill orders, communicate with individuals placing orders or visiting the online store, and for related purposes.


Pearson may offer opportunities to provide feedback or participate in surveys, including surveys evaluating Pearson products, services or sites. Participation is voluntary. Pearson collects information requested in the survey questions and uses the information to evaluate, support, maintain and improve products, services or sites, develop new products and services, conduct educational research and for other purposes specified in the survey.

Contests and Drawings

Occasionally, we may sponsor a contest or drawing. Participation is optional. Pearson collects name, contact information and other information specified on the entry form for the contest or drawing to conduct the contest or drawing. Pearson may collect additional personal information from the winners of a contest or drawing in order to award the prize and for tax reporting purposes, as required by law.


If you have elected to receive email newsletters or promotional mailings and special offers but want to unsubscribe, simply email information@informit.com.

Service Announcements

On rare occasions it is necessary to send out a strictly service related announcement. For instance, if our service is temporarily suspended for maintenance we might send users an email. Generally, users may not opt-out of these communications, though they can deactivate their account information. However, these communications are not promotional in nature.

Customer Service

We communicate with users on a regular basis to provide requested services and in regard to issues relating to their account we reply via email or phone in accordance with the users' wishes when a user submits their information through our Contact Us form.

Other Collection and Use of Information

Application and System Logs

Pearson automatically collects log data to help ensure the delivery, availability and security of this site. Log data may include technical information about how a user or visitor connected to this site, such as browser type, type of computer/device, operating system, internet service provider and IP address. We use this information for support purposes and to monitor the health of the site, identify problems, improve service, detect unauthorized access and fraudulent activity, prevent and respond to security incidents and appropriately scale computing resources.

Web Analytics

Pearson may use third party web trend analytical services, including Google Analytics, to collect visitor information, such as IP addresses, browser types, referring pages, pages visited and time spent on a particular site. While these analytical services collect and report information on an anonymous basis, they may use cookies to gather web trend information. The information gathered may enable Pearson (but not the third party web trend services) to link information with application and system log data. Pearson uses this information for system administration and to identify problems, improve service, detect unauthorized access and fraudulent activity, prevent and respond to security incidents, appropriately scale computing resources and otherwise support and deliver this site and its services.

Cookies and Related Technologies

This site uses cookies and similar technologies to personalize content, measure traffic patterns, control security, track use and access of information on this site, and provide interest-based messages and advertising. Users can manage and block the use of cookies through their browser. Disabling or blocking certain cookies may limit the functionality of this site.

Do Not Track

This site currently does not respond to Do Not Track signals.


Pearson uses appropriate physical, administrative and technical security measures to protect personal information from unauthorized access, use and disclosure.


This site is not directed to children under the age of 13.


Pearson may send or direct marketing communications to users, provided that

  • Pearson will not use personal information collected or processed as a K-12 school service provider for the purpose of directed or targeted advertising.
  • Such marketing is consistent with applicable law and Pearson's legal obligations.
  • Pearson will not knowingly direct or send marketing communications to an individual who has expressed a preference not to receive marketing.
  • Where required by applicable law, express or implied consent to marketing exists and has not been withdrawn.

Pearson may provide personal information to a third party service provider on a restricted basis to provide marketing solely on behalf of Pearson or an affiliate or customer for whom Pearson is a service provider. Marketing preferences may be changed at any time.

Correcting/Updating Personal Information

If a user's personally identifiable information changes (such as your postal address or email address), we provide a way to correct or update that user's personal data provided to us. This can be done on the Account page. If a user no longer desires our service and desires to delete his or her account, please contact us at customer-service@informit.com and we will process the deletion of a user's account.


Users can always make an informed choice as to whether they should proceed with certain services offered by InformIT. If you choose to remove yourself from our mailing list(s) simply visit the following page and uncheck any communication you no longer want to receive: www.informit.com/u.aspx.

Sale of Personal Information

Pearson does not rent or sell personal information in exchange for any payment of money.

While Pearson does not sell personal information, as defined in Nevada law, Nevada residents may email a request for no sale of their personal information to NevadaDesignatedRequest@pearson.com.

Supplemental Privacy Statement for California Residents

California residents should read our Supplemental privacy statement for California residents in conjunction with this Privacy Notice. The Supplemental privacy statement for California residents explains Pearson's commitment to comply with California law and applies to personal information of California residents collected in connection with this site and the Services.

Sharing and Disclosure

Pearson may disclose personal information, as follows:

  • As required by law.
  • With the consent of the individual (or their parent, if the individual is a minor)
  • In response to a subpoena, court order or legal process, to the extent permitted or required by law
  • To protect the security and safety of individuals, data, assets and systems, consistent with applicable law
  • In connection the sale, joint venture or other transfer of some or all of its company or assets, subject to the provisions of this Privacy Notice
  • To investigate or address actual or suspected fraud or other illegal activities
  • To exercise its legal rights, including enforcement of the Terms of Use for this site or another contract
  • To affiliated Pearson companies and other companies and organizations who perform work for Pearson and are obligated to protect the privacy of personal information consistent with this Privacy Notice
  • To a school, organization, company or government agency, where Pearson collects or processes the personal information in a school setting or on behalf of such organization, company or government agency.


This web site contains links to other sites. Please be aware that we are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of each and every web site that collects Personal Information. This privacy statement applies solely to information collected by this web site.

Requests and Contact

Please contact us about this Privacy Notice or if you have any requests or questions relating to the privacy of your personal information.

Changes to this Privacy Notice

We may revise this Privacy Notice through an updated posting. We will identify the effective date of the revision in the posting. Often, updates are made to provide greater clarity or to comply with changes in regulatory requirements. If the updates involve material changes to the collection, protection, use or disclosure of Personal Information, Pearson will provide notice of the change through a conspicuous notice on this site or other appropriate way. Continued use of the site after the effective date of a posted revision evidences acceptance. Please contact us if you have questions or concerns about the Privacy Notice or any objection to any revisions.

Last Update: November 17, 2020