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Using P/E to Find Value Stocks
It is common knowledge that value investors use fundamental analysis to pick undervalued stocks. Of which there are a large number of variables to review. However, one that is mostly associated with value investors is the P/E. The price-to-earnings ratio (P/E ratio or price multiple) is used to determine if a company's stock price is over or undervalued. Companies with a high P/E ratio are typically growth stocks. But, companies that have a low P/E are considered undervalued.
Is the company with the lower P/E always the better investment? The short answer is no. It depends on a few items. The stock’s P/E is the ratio of the stocks’ current market price divided by its earnings per share. So, if the P/E is 40, it means the investor is paying $40 for each dollar of earnings. If the P/E is 10, it means the investor is paying $10 for each dollar of earnings. Thus, a stock trading at 10X earnings is viewed as being cheaper than one trading at 40X its earnings. But it is unwise to just look at the P/E of the company without also looking at the P/E of overall market and the industry. For example, the trailing 12 month P/E of the S&P500 Index sheds some light on the overall market. And let’s assume we are considering a company in the Energy Sector, specifically in the Global Oil & Gas Refining & Marketing Industry of which there are 149. We would want to look at the Industry Median P/E. Plus, we want to look at the various P/Es of all the companies within that Industry to see where this company stands. Here are some of the numbers. First, the S&P 500 Index (ttm) P/E on 5/1/18 was at 24.2 for the overall market. See the graph below.
Second, the Industry Median P/E for this particular industry is 11.49. Third, the specific company’s P/E is 10.47. Some of the others have a P/E of 18.34, 42.13, 76.80, 36.00, 0.00, 20.88, 12.48, 7.77, 5.45, 0.08 and others. Nope, not going to list all 149 of them, but hopefully you are starting to get the idea. The key is the P/E of our specific company of 10.47 is way below the overall market compared to 24.2. We also included the P/E for the overall market since 1871 just to show you how much the actual number changes and is relative to time. See the graph below.
This is a great start and therefore we keep going. And at 10.47 its P/E is ranked 74% higher than the other 148 within the Industry, another great sign. It is worth noting that, yes there are some P/Es that are lower than the 10.47. Recall, as an investor doing fundamental analysis you cannot look at only one variable or indicator in evaluating a particular company. For example, at Port Wren Capital, LLC we look at over 194 variables or indicators. We look at the company, its industry as well as three competitors on a number of factors in our evaluation process. And that is only one step in our total process. You can see that P/E is only one element and why the investment research process takes time and skill. Our subscription service saves you hours of time and brings actionable investment research.
At Port Wren Capital, LLC, we specialize in picking specific undervalued U.S. stocks using fundamental analysis developed by Benjamin Graham using a five step process. We have beaten the S&P500, DJIA and NASDAQ benchmarks since we started 5 years ago on our own investments. Discover the difference for yourself. To learn more contact us today.
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