Investing In Stocks Using Price Earnings Ratios

0
Investing In Stocks Using Price Earnings Ratios

Why Use The Price Earnings Ratio  by Federico Garcia

This blog has previously shown statistical evidence that shows one should avoid high PE (price earnings) ratio stocks. A number of academic studies back this up. And value investors like Warren Buffett or Benjamin Graham essentially look for “cheap” stocks with good growth prospects. A quick way to see if a stock is “cheap” or “expensive” it to look at the PE ratio or the ratio of the price you pay to the earnings or profit you get associated with the stock.

Get The Full Warren Buffett Series in PDF

Get the entire 10-part series on Warren Buffett in PDF. Save it to your desktop, read it on your tablet, or email to your colleagues

Q4 2019 hedge fund letters, conferences and more

Filtering for the Right Stock

If I were to filter for a low PE stock today (March 2020) which one would I pick? Looking at big blue-chip companies, JPMorgan Chase, the biggest bank in the US, has had strong results recently. Its earnings grew from $9 a share in 2018 to $10.72 a share in 2019. It had positive results in both its lending business and its other financial businesses. Looking at today’s price of $120 and dividing by the $10.72 a share 2019 earnings gives JPMorgan Chase a PE ratio of 11.

The Role Of Knowledge In Asset Management

Active Management FundsIs there a link between intelligence, knowledge and successful investing? At first glance, it might appear as if there is. Wall Street is known for only hiring the best and brightest. However, some of the world’s most successful investors didn’t attend the world’s best universities and don’t claim to have a higher than average I.Q. Read More

What’s a “blue chip” company with a high price earnings ratio that I would avoid? Let’s look at Johnson & Johnson (JNJ). Although Johnson & Johnson, the biggest consumer goods company, saw revenues grow slightly in its fiscal year ended in 2019, the growth was minimal. The sales growth rate in 2019 was close to 0%, with the weakest results in the baby care segment. Compare that to the sales growth rate in 2018, which was almost 7%. Looking at today’s price of $140 and dividing by the $5.63 a share 2019 earnings, gives Johnson & Johnson a PE ratio of 25.

Comparing Results

The price earnings ratio tells a little bit about the business of these companies and a little bit about the price of their stocks. If PE ratio was your only guide you would choose to pay less for earnings. So you would buy JPMorgan at a PE ratio of 11, rather than Johnson & Johnson with its 25 PE ratio.

In this case, performance history would back you up. JPMorgan’s stock price (the blue line below) has outperformed if you look at the past 5 years or past 1 year. I would expect this trend to continue. Academic studies suggest that JPMorgan’s below average PE Ratio should increase over time or revert to the mean. That would mean the price would go up.

Price Earnings Ratios

Exceptions to the Rule

Although using this statistical takeaway is a great way to make sure you generally get good returns over time, there are exceptions to the rule. For example, over the past ten years or so many tech stocks have had price earnings ratios well above average, but have shown great performance in terms of their price growth. Take Amazon (AMZN) for example. It has shown amazing stock price growth with a PE ratio currently at 85, which is extremely high! And sometimes stock prices grow when the companies have no earnings at all. This is often the case with companies in an initial growth stage that exhibit strong sales growth but are reinvesting a lot as well.

Another extreme case is the case of a value trap. Value trap is an investing term for a stock that has a seemingly low valuation, but the stock price never goes anywhere. UBS stock has a PE ratio at 10, which is lower than JPMorgan’s, but its stock price has been stagnant since the Great Recession over a decade ago.

Conclusion

Since there are exceptions to the price earnings ratio rule of thumb, it’s important to understand the growth prospects of the companies you want to invest in. A great way to do this is to look at their quarterly SEC filings and investor relations homepages online.

The Price Earnings Ratio Stock Value Tracker is a great mobile app that provides you with an easy-to-use dashboard that shows you which stocks have low price earnings ratios and which ones have high PE ratios with live stock market data. Click here for more information!

Article by Federico Garcia

Updated on

Previous article 5G Technology: The Golden Age of the Internet and It’s Future in Mobile Communication
Next article Could alternative investments bail public pensions out?
Jacob Wolinsky is the founder of ValueWalk.com, a popular value investing and hedge fund focused investment website. Jacob worked as an equity analyst first at a micro-cap focused private equity firm, followed by a stint at a smid cap focused research shop. Jacob lives with his wife and four kids in Passaic NJ. - Email: jacob(at)valuewalk.com - Twitter username: JacobWolinsky - Full Disclosure: I do not purchase any equities anymore to avoid even the appearance of a conflict of interest and because at times I may receive grey areas of insider information. I have a few existing holdings from years ago, but I have sold off most of the equities and now only purchase mutual funds and some ETFs. I also own a few grams of Gold and Silver

No posts to display