The price earnings ratio (PE ratio) is regarded as an important metric for value investors. The value investor is always looking for stocks that may be undervalued, meaning that the current share price is less than the intrinsic value of the stock. A PE ratio that is low compared to the average in the industry in which the company is operating could indicate that a company is undervalued. This could be a signal for the value investor to move in and invest in shares in the company.
The price earnings ratio effectively shows the number of years of earnings at which the company is valued given the current level of the share price. This number in itself does not say very much about the company because the ratio has to be compared to those of the other companies operating in the same industry. Each sector has a historic average PE ratio that shows the average PE ratio over the years in the industry. The PE ratios of companies at any particular time could be above or below the average, so the current as well as historic average PE ratio of companies in the industry should be examined.
For example, technology stocks have traditionally traded at a relatively high PE ratio. During the dot com boom the PE ratios in the sector went up well above the historic average, then after the dotcom bubble burst this high period ended and since then they have often traded at below the historic average. The historic average PE ratio should therefore be considered in the light of the current situation in the industry. Another factor to be taken into account is the general economic situation. Since the recession of 2008 and the following years the price earnings ratios of technology stocks have been down and this needs to be taken into account by the value investor when looking for value stocks.
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When the value investor finds a stock in a particular sector whose PE ratio is low compared to most of its competitors in the industry this is not a reason to rush into buying that share but is an indicator that further analysis of the fundamentals of the company could be worthwhile. The important next step is to analyze the reasons why the PE ratio is low at this particular time. If other companies in the industrial sector have higher PE ratios then the reason is unlikely to be due to the state of the sector or to the general economic situation. It could however be due to a problem in the individual company. This could be due to any of a number of other factors including recent bad publicity, a management problem, insider trading or a recent profit warning. Companies in an industry could be operating in many parts of the world and one company could have operating divisions that were hit by a natural disaster such as the recent earthquake in Japan.
Once the investor has identified a reason for the low PE ratio it may be necessary to determine if there is a genuine reason for the low ratio or if it is due to market emotion that has no logical basis. Although there is a myth of an entirely rational market based on full information available to investors, the reality as recent months in the stock markets have shown is that share prices swing from one day to another based on purely emotional factors. It is not therefore possible to assess the value of a share based on its price today as compared to its price yesterday. The value can only be assessed using the best possible analysis of the fundamentals to arrive at a figure for the intrinsic value of the company.
This analysis of the intrinsic value of the company would normally be based on criteria such as future profit projections or discounted future net cash flows. To arrive at an idea of the intrinsic value of the company the investor must know something about the business that the company is engaged in. The motto for the value investor is not to invest in what you don’t understand. The final decision on intrinsic value must take into account factors such as the investor’s opinion of the management of the company which is not purely based on figures but requires a value judgment.
Once a view has been reached on the intrinsic value, the investor can compare that intrinsic value to the market valuation of the share. In principle if the market value is below the intrinsic value this is a reason to consider buying the share. The value investor should always building a margin of safety to ensure that this is still a good buy if there are some inaccuracies in the analysis, as there will be in any attempt to predict the future. If after allowing for this margin of safety the stock still appears to be undervalued, then it can potentially be acquired as a value stock.
The important factors in the analysis of a share with a low price earnings ratio are firstly the conclusion the investor comes to as to the reasons for this low PE ratio and secondly the investor’s calculation of the intrinsic value of the company. If the investor is correct, the market will gradually realize the potential of the company and the stock price may rise. An estimate of intrinsic value can often be wrong and this is why the margin of safety should never be forgotten.