Why the Price to Earnings Ratio of a stock matters.
The Price to Earnings ratio is a simple measure that takes the Price a
stock is trading at over the years EPS. As an example if a stock is
trading at $10.00 per share and has earnings of $1.00 its price to
earnings ratio would be 10. As a general rule short term traders,
momentum investors and others are taught that the price to earnings
ratio does not matter. I think that this can be a mistake, and the
longer out your time frame goes the bigger that mistake can become.
Stocks with high price to earnings ratio's are generally over owned
and over loved by institutional investors, this can become
particularly dangerous in a market route, such as we have seen over
the last few weeks, when everyone heads for the same exit at the same
time. Many times a stock with a low multiple is one that is not
heavily owned yet for any number of reasons: It's average volume might
be too small, its sales not high enough yet, market cap considerations
and any number of other reasons.
The price of a stock basically can appreciate in one of two ways: EPS
expansion and or PE expansion. If you can get both of them working in
your favor I tend to think of it as a form of leverage. Let me give
you an example. Lets assume we have two stocks, I'm just going to call
them A and B. Both stocks are trading at $20.00 per share and will
experience EPS growth of 40% over the course of the next year. Stock A
is heavily owned and trades with a PE of 25, earnings of $0.80 per
share. Stock B has overall sales under $100 million so it is largely
overlooked by the traditional players on The Street. As a result it
only carries a Price to Earnings Multiple of 10, the over all EPS
being $2.00 per share.
As stated above, over the course of the next year the EPS of both
companies will expand by 40%. company A will now have EPS of $1.12 per
share, while company B's will have grown to $2.80. As a result of
Company B's continued growth sales are now above $100 million and
certain firms that have overlooked it in the past are now covering it
with buy recommendations. This has resulted in more demand for the
stock, pu****ng up the average daily volume which has brought more
attention to it and so on. Everything has remained pretty much the
same with company A. It now trades at $28.00 per share, based upon
earnings growth, and has given a healthy 40% return to shareholders.
However, because of the increased attention company B's price to
earnings ratio has grown from 10 to 12, so now with its EPS of $2.80
the stock trades at $33.60 per share, a gain of 68% on the year.
Both companies have given shareholders superior returns, and most
investors would have happy to have had either company in their
****tfolio. Company B though had more explosive potential though, the
result of being an undiscovered name to most of the street. The
examples and figures used above are obviously simplifications used for
the sake of example. In real life there are a number of factors that
can lead to the Price to Earnings ratio of a stock being lower then
that of its peers. Careful investigation as to reason for the low PE
is needed, otherwise what looks like gold today could turn out to be
nothing but fool's gold tomorrow.
It is worth noting that buying a stock simply for its low PE is
probably more foolish than not buying one because of a high PE. There
are a number of factors that can cause the stock to trade at a low
multiple, some of them favorable to you, most not. It's im****tant to
learn how to sort the gold from the fools gold. In another article I
will cover what traits to look for, and what traits to avoid, in
stocks with a low PE. Until then I hope this have given you some food
for thought and will help you head in a more profitable direction with
your own trading.
If you have any comments or questions please feel free to ask or visit
my blog @[EMAIL PROTECTED]
http://brandonfredrickson.blogspot.com/
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