When it comes to buying something, everybody wants a deal, right?
It doesn't even matter if the person is rich or poor. In that, regardless of whether an individual can barely afford something or it barely makes a blimp on the screen, only one thing matters: they got a deal. It seems that American capitalism and culture have not only instilled a high significance level on the conceptual value of a dollar but the art of a deal as well. Due to this reality, it shouldn't be much of a surprise then that American investors constantly flock to the current P/E ratio when they want to get a quick idea of whether a stock is a real "deal", fairly priced, or expensive.
While some would say this is makes perfect sense, I would point out that there is a huge chink in the armor that protects this go-to price-multiple valuation.
What's the problem with it?
In my opinion, there are two shortcomings to using the current P/E ratio when attempting to quickly eyeball a company and determining whether it's worth researching further relative to its P/E valuation.
Flaw Number #1:
The current P/E ratio is based off the last 12-trailing months or 4-quarters worth of earnings. This means the current P/E ratio doesn't illustrate the current cost of buying into future earnings but the current cost to buy into past earnings. Still, investors buy and gain exposure to future potential earnings, not past earnings, when investing in a stock. Herein lies the first flaw with the current P/E ratio when viewed in isolation and used in eyeballing analysis.
Flaw Number #2:
2. The current P/E ratio illustrates how high or low investors expectations are relative to a company's future earnings based off past earnings. The problem here is that a large percentage investors, both professional and retail, over the long-term tend to underperform the market. Therefore, basing an investment decision based off an aggregated price-multiple valuation, which is potentially tainted by underperforming investors, seems like a questionable proposition.
So does this mean the current P/E ratio is worthless? Not in the slightest bit!
In my view, what it does mean is that investors should never make a decision on whether a stock is worth researching further solely based off viewing this one price-multiple valuation in isolation.
Then how can an investor make the current P/E ratio a quick and more precise investing tool? One way is to pair it up with a 3-year EPS growth rate. In my view, pairing the current P/E ratio with an unbiased growth metric helps create a more objective valuation snapshot for investors relative to what the current P/E ratio is attempting to illustrate.
Stock Price X: $10
Dividend Yield: 3%
Current P/E Ratio: 10
3-Year Annualized Earnings Growth Rate: 20%
Making the assumption that the example stock's future earnings over the next year will continue to at least equal the 3-year annualized earnings growth rate, an investor can quickly conclude that the stock could be mispriced.
Need further explaining?
Basically, the market believes the stock is only worth 10 times its past earnings. From a value-oriented valuation perspective, this stock is "cheap". Still, by noticing that the stock's 3-year annualized earnings growth rate is higher than its current P/E, this helps objectively validate the idea that the stock is actually cheap relative to its future earnings potential.
The take away here is that by adding one simple step that only perhaps takes 2 minutes to implement, an investor can fix the flaws that are often associated with using the current P/E ratio in isolation to determine if a stock is indeed cheap or not.
Putting Practice Into Action:
To help put this concept into practice, I decided to turn this concept into a quick large-cap. dividend stock screen. The first action I took was to screen for any stock that had a dividend yield of 3% or higher but only traded with a current P/E of 10 or lower. From this narrowed pool I then screened for dividend stocks that had a 3-year annualized EPS growth rate greater than 10.
Below are a few dividend stocks that are trading at a cheap valuation from a value-oriented standpoint relative to their current P/E ratio when cross-referenced against their 3-year annualized EPS growth rate.
The dividend stocks are listed by market cap. from largest to smallest:
|Stock||Market Cap.||Div. Yield||Current P/E||EPS Gr. % (3-Yr.)|
|Intel Corp (INTC)||$104,297M||4.15%||9.16||37.47%|
|Statoil ASA (STO)||$84,308M||3.43%||5.74||22.07%|
|Banco Santander SA (BSBR)||$27,782M||3.72%||8.44||16.97%|
|Sasol, Ltd. (SSL)||$27,623M||4.82%||9.44||19.54%|
|Raytheon Company (RTN)||$18,433M||3.58%||9.53||10.34%|
|Gold Fields (GFI)||$8,491M||4.26%||9.62||17.39%|
|Yanzhaou Coal Mining Company (YZC)||$8,327M||4.80%||6.68||11.30%|
|Cliffs Natural Resources (CLF)||$5,089M||6.03%||5.53||34.61%|
I hope this article assists dividend investors as they do their own due diligence and research on large-cap. dividend stocks that trade with a low current P/E ratio but operate with a strong multi-year EPS growth rate.
Additional disclosure: None of the information or analysis here should be misconstrued as direct individual investment advice.