Everybody enjoys finding a good bargain. Everyone likes to think that when they bought something they got a good deal. These desires constitute the fundamental nature of value investors. But not only are value investors hoping that they bought at a low price (or that they made a good deal), they are hoping that sooner or later the public will recognize the "bargain" and swoop in to purchase themselves and drive up the price. I have always been a value guy; looking for the best buy, shopping around and finally pulling the trigger on a purchase.
How do you value a stock? There are many ways to determine a stock's value as compared to its price, but perhaps the most common and arguably most useful is the price - earnings ratio. The P/E ratio is the price of a single share of stock divided by the earnings per share. The lower the P/E, the better value the stock.
Thus for Coca-Cola (NYSE:KO), the current price of $40 divided by the earnings per share of 1.90, produces a P/E ratio of $40 divided by 1.90 or a P/E ratio of 21. Most would consider Coke to be more of a growth stock instead of a value based on a P/E that high. A more likely value play might be Wells Fargo Bank (WFC), which has a P/E of about 12, or Pfizer (NYSE:PFE), with a P/E of 8.
In addition to being sold at a low price, value stocks also typically pay a dividend, which further enhances the value. Coke's dividend is 2.8%, Wells Fargo is 2.7% and Pfizer's yield is 3.3%. This leads me to one of my favorites - BP.
BP has an incredibly low P/E of 5.1 and a dividend yield of 5.2%. Rarely do you see a price-earnings ratio in the range of 5 or less and although there are many quality stocks paying 2% to 4% dividends, yields at 5% or higher are much less common, particularly in high-quality, blue-chip equities.
In my many years of investing I have never seen a stock with a P/E ratio LOWER than its yield. I'm surely not saying it hasn't happened, and I'm sure we may have some bright readers that will be happy to give examples in the comments section below, but BP is the only example I know.
As a caveat, I must warn that sometimes, if not often times a low P/E ratio may indicate a problem with the stock. BP certainly has its share of detractors and nay sayers who harp on the remaining uncertainties associated with litigation surrounding the liability of BP, Transocean RIG and Haliburton HAL. In a previous article I addressed my view on BP's exposure. BP is an incredible value play and will pay you 5.2% to wait for the resolution of the uncertainties of litigation.