One of the most commonly used metrics for determining a company’s worth is the price-earnings (P/E) ratio, which is calculated by dividing the current stock price by the trailing 12-month earnings per share. The P/E ratio is closely watched by investors as it connects a company’s recent earnings performance to the market’s expectations of its future performance. Investors are willing to pay a higher multiple of current earnings for the promise of future earnings in line with their expectations.
There are models available to help assess if a company’s price-earnings ratio is reasonable, such as the relative price-earnings ratio approach, which compares a stock’s P/E ratio to that of the overall market or the company’s industry. AAII’s P/E Relative screen has outperformed the S&P 500 index since its inception, generating a compound annual price gain of 13.8% compared to the S&P 500’s 6.3% annual return over the same period.
The price-earnings relative is calculated by dividing a company’s P/E ratio by that of the market, indicating whether a company’s valuation is above or below market levels. Changes in the price-earnings relative may signal shifts in market expectations regarding a company’s future earnings potential. AAII’s stock screening program provides filtering criteria to screen based on the price-earnings relative, along with other measures, to identify potentially undervalued stocks.
Calculating the price-earnings relative requires the current market P/E ratio and the five-year average P/E relative for the stock being examined. By multiplying the market’s current P/E ratio by the company’s P/E relative, an adjusted P/E ratio is obtained for fair market valuation. Stocks with P/E relative averages above 1.00 are typically valued higher than the market, while those below 1.00 indicate a lower valuation. Screening for undervalued stocks involves excluding companies with negative earnings or unusually high P/E ratios in recent years.
Investors often seek catalysts to attract attention to undervalued companies and boost their stock prices. Upward earnings revisions and positive surprises can prompt a reevaluation of a company’s prospects, leading to price adjustments. Price momentum is also considered a sign of favorable market recognition. Screening for stocks based on P/E ratios can help identify companies that have strayed from their typical valuation levels and may warrant further analysis.
In conclusion, using P/E ratios to screen for stocks can help identify undervalued companies that may have potential for future growth. However, caution is advised when investing in low P/E stocks, and thorough due diligence is necessary before making investment decisions. The success of the P/E approach depends on well-founded inputs and expectations. It is important to note that stocks meeting the criteria of the screening approach are not a recommended buy list, and additional research is essential for informed investing decisions.
