When reading about value investing, it is common to see the PE ratio of a company commonly referred to as one of the metrics that value investors look at. In this article, we will explore: why are PE ratios often cited in regards to value investing? Does a low PE ratio always make a good investment? And what are the pitfalls of a low PE ratio?
A low PE ratio can make a good investment when the company’s PE ratio is lower than its’ industry, the stock temporarily falls on bad publicity, or is undiscovered by the market. The stock could be an excellent investment if earnings are likely to grow or is bought before being discovered by the market.
What is the PE ratio?
The price-to-earnings (PE ratio) is calculated by dividing the stock’s current price by its earnings per share over 12 months. For example, if a stock is trading at $10 and has earnings per share of $1, it would have a PE ratio of 10 ($10 divided by $1). If nothing else changed, the investor would make their money back in 10 years.
Value investors often use it to help them determine the market value of a company’s stock compared to its earnings, i.e., what is the market willing to pay for a stock now compared to its past or potential future earnings. The PE ratio is often used to determine if a stock is undervalued or overvalued, especially when compared to companies of a similar nature and their’ industry sector. A low PE ratio could mean that the current stock price is cheap compared to its earnings and is often used as a metric by value investors to find undervalued companies. However, many factors can affect a PE ratio, and investors must look at them individually before investing.
Why do stocks have low PE Ratios?
It depends. As mentioned above, PE ratios tend to vary from industry to industry, partly due to the overall ability of companies in that sector to earn profit. For example, technology stocks usually have a higher PE ratio than energy stocks as it is a lot less expensive to produce and distribute software than build and maintain energy infrastructure. However, it is all relative; a PE ratio of 15 for a technology stock could be considered cheap when the overall ratio for the technology sector is 30 could, whereas a ratio of 12 for an energy stock could be considered reasonable when the overall ratio for the industry is 8. See the chart below for the average PE ratio by the industry for the past five years.
Conversely, a company in the energy sector with a very low ratio could be a better investment than a technology company with a low PE for its industry; the energy company could be highly undervalued and have a very high potential for its stock to increase more rapidly than any technology company. For example, if the energy company with great fundamentals had a PE of 1 due to temporary negative news, the future returns could be 10x in a very short amount of time.
Can a stock with a high PE ratio be a good investment?
A stock with a high PE ratio can also be a good investment. For example, let’s say a company’s stock is trading at $30 per share and has a PE of 30, which is considered high for its sector, earned $1 per share last year, and in the following year, it is expected to earn $3 per share. If the stock price did not change during that time, the company would have a PE ratio of 10 ($30 divided by $3), making it cheap for its sector.
Are stocks with low PE ratios good investments?
A PE ratio of 1 is often based on the expected future earnings and not present earnings. For example, in 2012, Fiat Chrysler was trading at $5 per share with a PE ratio of 1, and they only expected to earn $5 per share in 2018. Still, over that time, the earnings far exceeded expectations, and, as a result, the stock increased over seven times. The trick, of course, is correctly estimating that earnings will exceed expectations. This can only be done through a deep understanding of the business. This is an example of what value investors call having a margin of safety.
However, a company with a low PE can look attractive on the surface but could have severe underlying issues. For example, they may have declining earnings from the competition, increasing production costs, or lack of innovation. It is up to the investor to decide whether this is temporary or permanent. A low ratio could also mean a company is about to go bankrupt. However, unlike declining earnings, it is much less likely that the company will be able to turn itself around and much more likely that the company will cease to exist.
Watch out for value traps
A value trap is a stock that appears cheap because it has a low ratio relative to its historical ratio or its industry sector. One of the dangers of a value trap is that the stock continues to be depressed or even drops further after the investor has purchased the shares. A value trap is often due to a lack of continuing to innovate, a loss of competitive advantage, an inability to manage costs, or poor executive management. Even if the company has a history of turning itself around, there is no guarantee that it will do it again. Only thorough detective work will help the investor determine if the problem is temporary or permanent.
It is important to remember that much-hidden information goes into the PE ratio. It is up to the investor to discover the underlying factors and decide if the price is attractive. The PE ratio is only one factor in your research in determining the company’s strength and how much you should pay for it. Comparing the company to similar companies in the industry is a great measuring stick.
