How to Use P/E Ratios in Selecting Stocks
by Gene Walden
The great mistake made by the public is paying attention to prices instead of values.
-- Charles H. Dow
A lot of novice investors like to buy "cheap" stocks. There`s nothing wrong with that, except that "cheap" to them often refers to the price of the stock--not the value. They like stocks that cost $5 or $10 a share because they can buy more shares.
But experienced investors have an entirely different concept of "cheap." In terms of value, a $100 stock may be cheaper than a $3 stock. Value investors look for stocks with inordinately low price/earnings ratios--not stocks that sell for a few dollars.
The price/earnings ratio--known in the business as the "P/E"--is the most commonly-used measure of a stock`s value. Many investors decide which stocks to buy and sell based largely on the P/E. (The P/Es are listed every day in the stock tables of most major newspapers.) Investors often watch the P/Es as closely as the stock price itself. It`s a measure every serious investor should understand.
Literally translated, the price/earnings ratio means the stock price divided by the earnings per share. For example:
* A $20 stock with earnings of $1 per share would have a P/E of 20 (20 divided by 1).
* A $100 stock with earnings of $10 a share would have a P/E of 10. (100 divided by 10).
In value terms, the $100 stock with the 10 P/E would be cheaper than the $20 stock with the P/E of 20.
P/Es are a lot like golf scores--the lower the better. Most established blue chip stocks have P/Es in the range of 10 to 30. (Value investors would tend to be more interested in stocks with P/Es of 10 or under.) In comparing P/Es, you might think of buying a stock in much the same way as you would buying a business. If you can buy a business that earns $1 a year for $10, (10 P/E), that would seem to be a much better value than to buy a business with that same $1 of earnings for $30 (30 P/E).
So why doesn`t everyone buy stocks with the lowest possible P/E? Because some companies really are worth more than others. Great companies with fast earnings growth command a premium over slow-growing companies, as well they should.
"We`re willing to pay a higher P/E ratio for companies that are growing at 30 to 40 percent per year than companies growing at 10 to 15 percent," says Lee Kopp, one of the nation`s top ranked money managers the past 10 years."
Kopp says that, to be fairly priced, a stock`s P/E should roughly reflect its earnings growth rate. "The suggestion from Wall Street is that if the earnings are growing at 30 to 40 percent, you can apply a 30 to 40 P/E multiplier. If it`s growing at 15 percent per year, you can apply a 15 P/E multiplier."
But Kopp concedes that selecting stocks based on P/E ratios can be tricky. "When you look at P/E ratios, every industry has a different average," explains Kopp. "The biotech industry may sell at an infinite price-earnings ratio because there may not be any earnings. A more mundane industry might sell at an average P/E ratio of seven. So you really have to look at the average of that industry."
Perhaps the best point of comparison is the stock`s own historical P/E ratios. If a stock has had a 20 P/E through most of its history, then you would probably be safe to buy the stock at around 20 or less (assuming its earnings are still about the same). If the P/E has climbed closer to 30, you might be better served to look for other opportunities, and wait for the P/E of that stock to drop back down to its normal range.
But one thing you should never do is judge a stock by its price alone. Even if you have only $1,000 to invest, you still need to make your buying decision based on the stock`s value, not its price. There is no rule that says you have to buy an even lot of shares. It`s totally irrelevant. Odd lots are just as easy to buy and sell as even lots of 100 or 1,000. Look for the best stock at any price. If your choice is between buying 10 shares of a $100 stock with a growth rate of 20 percent and a P/E of 20, or buying 200 shares of a $5 stock also with a growth rate of 20 percent but with a P/E of 30, the choice is obvious. You buy the "cheap" stock--the $100 stock with the lower P/E.
He who wants a rose must respect the thorn.
If you want to own the stock of a fast-rising company, you`ll have to pay a premium. Just be careful not to pay too much. The higher the stock`s price/earnings ratio, the more you stand to lose if the earnings suddenly go south.
"A high P/E stock that is starting to lose growth momentum can spell trouble," says American Century Ultra Investors Fund manager Christopher Boyd.
Some of the highest-flying stocks of 1996--when the technology sector was skyrocketing--became some of the biggest losers of 1997 when many of those stocks returned to earth. In many cases, the stocks fared poorly not because of any weakness in their earnings, but because of their exorbitant P/E rations. In fact, in some cases, the stock price dropped even though earnings continued to rise. PairGain Technology, for instance, dropped from $30 a share to $19 in 1997 even though the company`s earnings grew about 50 percent (through the first three quarters of 1997). But the stock`s 75 P/E was too rich for Wall Street, which drove it down to about 30 by the end of the year.
APAC Teleservices, which had a P/E of about 80 at the end of 1996, saw its stock price drop from about $38 a share to $13.50 in 1997, even though its earnings remained about the same. Its P/E dropped from 79 to 23.
Acend Communications, which had an 89 P/E in 1996, saw its earnings flatten out in 1997 (although its revenues continued to climb), leading to a plunge in share prices from $62 to about $25.
The disaster can be even more dramatic for high P/E stocks that suddenly see a drop in earnings. Shiva Corp., a computer networking company that had a 65 P/E in 1996, saw its earnings drop from 54 cents a share in 1996 to a loss of about 40 cents a share through the first three quarters of 1997. The result was a 75 percent drop in the stock price, from $35 to $8 a share.
Oxford Health Plans, which had a 55 P/E in 1996, reported a 99 cent loss in the third quarter of 1997. The bad news sent the stock tumbling from $59 at the start of 1997 to just $15.50 at the end of the year.
If you want to own some of the market`s fastest-growing companies, you`ll have to accept a fairly high P/E. But be sure the P/E isn`t completely out of whack, because the higher the P/E the greater the chance of a dramatic decline in the stock price if the company`s earnings growth suddenly starts to slide.
The object of war is not to die for your country, but to make the other bastard die for his.
-- General George Patton
From time to time, the P/E ratios of an entire sector become irrationally high. If you own stocks in an over-priced sector, you can save yourself some heavy losses by unloading those stocks before they begin to plummet.
There have been several times in recent history when P/Es of certain stocks became dangerously high. Those times are usually easy to recognize because the rationale for the high prices from the experts on Wall Street is almost always the same: "This time it`s different. These stocks can support exorbitantly high P/Es because.... (fill in the blank)."
Don`t believe a word of it. Their decline is eminent. A brief history lesson:
In the early 1980s, high tech start-up stocks and biotech stocks were the rage with investors who believed that there could be no end to their spectacular growth. Little matter that many of those companies still had no earnings, or very small earnings, and no track record. Investors were still bidding up the prices. P/E ratios climbed into the 50 to 100 range. And the rationalizations from Wall Street`s experts began. "This stocks are differen from the blue chips. They can support higher P/Es because of their potential for rapid growth." When the rapid growth never materialized, investors lost interest in the sector, and prices fell through the floor. Stocks trading at one point as high as $30 or $40 a share were suddenly going begging at $6 or $8.
In the late 1980s, Japanese stocks roared to record levels. Many stocks carried P/Es as high as 100 to 200, virtually unheard levels in the history of the stock market. But unfazed investors continued to buy, while Japanese brokers continued to tout the stocks. "This time it`s different," they would say. "This is the great Japanese financial empire, an empire that is taking over the world`s financial markets, the world`s manufacturing markets, and the world`s high technology markets. These stocks can support the higher P/E ratios because they are part of this great Japanese economic machine." And suddenly the machine ground to a halt, the bottom fell out of the Japanese economy, and hundreds of stocks dropped to a fraction of their former highs. A decade later, Japan`s Nikki Stock Exchange is still trading at about half of its peak level in the late 1980s.
In 1991 medical stocks suddenly caught fire. Merck climbed 80 percent. Pfizer went from $40 to $84 a share. Stryker went from $16 to $50. Across the board, medical stocks were climbing far faster than the market averages. P/Es were moving into the 40 to 70 range. And again, the rationalizations from Wall Street analysts began to fly. "This time it`s different. The world`s population is aging, and the need for medical products will continue to expand. That`s why these stocks can support high P/Es." But in 1992, when presidential candidate Bill Clinton began talking about health care cost containment, Wall Street began to take another look at medical stocks. And suddenly, those stocks began to slide, and continued to slide for about two years to the point where great stocks with great earnings such as Merck and Bristol-Myers were actually carrying P/Es in the low teens. They went from over-priced to under-priced, until Wall Street finally rediscovered them in 1995, and pushed their prices back up to fair market value.
If you own stocks of a sector with P/Es that seem way out of line, be prepared to lighten your position. Your sell signal will be those wise words from Wall Street, "but this time it`s different." When you hear that, get out, take your profit, and move on. Invoke the "greater fools theory" to your own benefit, and let the next guy take the fall. Or as General Patton would put it, "Let the bastards eat lead."
I`m not cheap, I just want a good deal.
-- Dennis Kleve
It pays to shop around in the stock market. If high P/E stocks have you worried, you might consider the other extreme, low P/E stocks--the stocks that no one else wants.
Some money managers specialize exclusively in low P/E stocks with good success. In fact, studies have shown that low P/E stocks, as a group, tend to outperform the overall market. "There is some evidence that a portfolio of stocks with relatively low earnings multiples has often produced above average rates of return," says Princeton professor and author Burton Malkiel. "It has also been found that stocks that sell at low multiples of their book values have tended to produce higher subsequent returns, a finding consistent with the views that Graham and Dodd first expounded in 1934 and later championed by Warren Buffett. I would point out, however, that stocks that sell at low multiples of earnings and book values may indeed be riskier."
Money manager Lee Kopp points out another drawback to investors who build a portfolio of low P/E stocks. "They`re missing out on some great opportunities. They have their heads in the sand." If you stick with low P/E stocks, you`ll never own the great companies. They always command a premium. You`ll never see companies like Coca-Cola and Microsoft in your broker`s bargain bin.
But for short term investments, low P/E stocks can provide some surprising returns. Don`t build your entire portfolio around them, but if you keep an eye out for low P/E stocks, you might be able to catch some big gains on the turn-around.
Where can you find low P/E stocks? P/E ratios are listed in the stock tables of the Wall Street Journal, Investors` Business Daily and most major newspapers. An easier way to find cheap stocks is through the Value Line Investment Survey (which should be available at your public library). Value Line publishes a list of the lowest P/E stocks in each of its weekly updates.