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.