The P/E ratio is probably the most commonly used metric to determine if a stock is cheap or expensive.
Before we even start, it is important to note that P/E ratios vary from industry to industry. What might be considered a low ratio for one industry, can be a high ratio for another.
It’s important to always keep this in mind, so you don’t compare apples to oranges.
In this article, we’ll look at:
- What a low P/E ratio means
- Potential reasons why a stock has a low P/E
- If you should buy low P/E stocks
- The upside of investing in low P/E stocks
And at the bottom, there will be a conclusion if you don’t feel like reading the whole article.
First of all, you get the P/E ratio by dividing the Share Price by the EPS (Earnings Per Share.) For example, a stock with a $30 share price and a $3 EPS would have a P/E ratio of 10 while a stock with a share price of $15 and a $3 EPS would have a P/E ratio of 5.
(When you use the EPS from the last four quarters to divide the share price, it’s called a trailing P/E. If you use the expected EPS for the four coming quarters, it’s called a forward P/E.)
The example above shows you that the cheaper the share price is relative to earnings, the lower the P/E ratio is.
In other words, a low P/E means that the stock is cheap relative to its earnings and a high P/E means that it’s expensive.
But just because the P/E is low, you shouldn’t automatically assume the stock is undervalued. Some stocks are justified in having low P/E ratios, while others are not. So let’s look at some potential reasons why a stock would have a low P/E.
Why Some Stocks Have Low P/E Ratios
As we just talked about, a low P/E means that the share price is low relative to the stock’s earnings. So why aren’t investors willing to pay more for these stocks?
One reason is that the company is at a mature stage in its life. These companies have gotten to a point where they aren’t growing anymore. The earnings you pay for today, are not likely to change for the better tomorrow, so why would you be willing to pay anything other than a relatively low price?
The next reason is probably more common and not totally unlike the previous one. The reason is: Expectations.
Investors, for one reason or another, don’t expect these stocks to grow their earnings in the coming years. The expectations are low and so is the price. It’s the opposite of high P/E stocks where the expectations are high, and therefore the price.
Now, the market is not always right in its assessments and that is what creates undervalued stocks. When the market puts stocks in the low P/E doghouse, they are sometimes wrong in doing so and that is something you can potentially take advantage of.
What was it Uncle Ben said to Spiderman again? With low expectations come great possibilities? Yeah, that was it.
Should You Buy Low P/E Stocks?
Whether or not you should buy low P/E stocks is highly situational and requires more work than just looking at the P/E ratio alone.
You should always conduct a fundamental analysis, and that goes for any investment, low P/E or not. If you don’t know how to do one, here is an article.
Even if you shouldn’t buy a stock simply because it has a low P/E there has been some very interesting research on the performance of low vs. high P/E stocks which I will share with you.
David Dreman dedicates a whole chapter in his book Contrarian Investment Strategies to the research he conducted on how an earnings surprise affects the stock prices on low and high P/E stocks.
He studied the 1500 largest companies over a period of 37 years. He measured both negative and positive earnings surprises and their effect on prices. (If the analysts estimated an EPS of $1.2 for a stock and it got a $1 EPS, this counts as a negative surprise.) The results are surprising.
He found that negative earnings surprises had a much worse effect on high P/E stocks than they did on low P/E ones. Why? Expectations. High P/E stocks are expected to perform well. That’s why investors pay high prices for these issues.
Conversely, little to no expectations are placed on the low P/E stocks, so when they have a negative earnings surprise, no one is surprised.
Not only that, he also found that positive earnings surprises had less of a positive impact on high P/E stocks than they did on low P/E stocks.
Why? Again the answer is expectations. High P/E stocks are expected to perform well and when they do, few are surprised. But on the other hand, low P/E stocks are expected to perform badly, so when they have a positive earnings surprise, investors are pleasantly surprised.
You can read more about earnings reports and their effect on stock prices here.
High vs. Low P/E Stocks, risk and returns
You could argue that low P/E stocks are inherently less risky than medium to high P/E stocks because of the relatively low price you pay for them.
This seems to be the case, at least according to the same book I mentioned before. In the period from 1970 to 2010, the author researched bear market returns of high and low P/E stocks.
The winner was again low P/E stocks. High P/E stocks had a quarterly return of -9.5% in bear markets, while low P/E had -5.4%. (The market average was -7.6%.)
From 2000 to 2010, in what is now known as the lost decade, the market had an average annual return of 5,6%, high P/E stocks had an average of 0%, and low P/E stocks had a return of 11.7%.
All this goes to show how important it is to consider prices when investing in stocks.
Another way to look at it, which might put it into a better perspective, is that high P/E stocks are the popular stocks for which investors are willing to pay hefty prices. The darling stocks everyone loves.
While low P/E stocks are the dogs, the discarded, forgotten, and overlooked stocks.
A low P/E ratio means that the stock is cheap, relative to its earnings.
It is important to know that one P/E ratio might be considered low for one industry but not for another. So always compare P/E ratios to companies operating in the same industry.
Since the share price of low P/E stocks is low, you could make the argument that the expectations investors have of these stocks are generally low.
And low expectations are usually a strength, while high expectations are a weakness.
This explains the above-average performance of low P/E stocks and the below-average performance of high P/E stocks and also why they react differently to surprises in earnings, whether it’s negative or positive