I have been coming to Seeking Alpha for almost two years now. I am addicted to it, much the same way that some folks are addicted to Facebook. I look forward to coming here and reading the articles and I especially enjoy reading commentary.
There is one thing that I've noticed though. I haven't seen or heard from a number of people who used to be regulars here. I guess things change and people move on. But what I find particularly interesting is the number of new people that are coming to SA and participating in the discussions.
Many of these new visitors are new investors. They are looking for advice, looking for guidance, and looking for support. Many are hungry for knowledge and every time I read a comment from a newbie, I get excited. They are in the same place I was 40 years ago, trying to figure this investment thing out.
SOMETHING OF INTEREST
I come across articles every day that are very interesting and thought provoking. Recently I found an article that attracted my attention right away, because of the title. The article:
The tone of the article is set with this opening statement:
There's a lot of rumors on how Chipotle (NYSE:CMG) cannot sustain its rising P/E ratio of 57.5. Of course these speculations occur when a stock becomes overbought or oversold; this is not news on Wall Street, as publications usually sprout as the see-saw wobbles from one extremity to the other. Before I dive into the valuation part, let me first state that even historical P/E ratios are at times useless. What is also pointless, is for investors to compare similar quality companies such as Panera Bread (NASDAQ:PNRA) or Tim Horton's (NYSE:THI), hinting that Chipotle should trade at similar P/E levels. This is as 100% accurate as technical analysis.
HERE'S WHAT I KNOW
Being somewhat simple by nature, I have always believed that PE Ratios are very important in judging the value of a particular company. Now, don't get too far ahead of yourself, here. I am not saying that PE Ratios are the only metric for judging a stock's intrinsic value, but I am saying that it is an important part of a total analysis of value.
For all intents and purposes, the PE Ratio is a measure of a stock's price, relative to the stock's earnings. There are PEs for "trailing 12 months," for "most recent full year," and "full year forward." Each one of those will be somewhat different, based on the period of time that the metric is looking at. Let me explain:
Trailing 12 Months
Measures the current price of the stock divided by the earnings per share over the last 12-month period, without regard for the calendar year or company fiscal calendar. It is a moving average and gives you a snapshot in time.
Most-Recent Full Year
Measures the current price of the stock relative to the earnings generated for the fiscal or calendar year. It is a ratio of actual earnings reported by the company.
Measures the current price of the stock relative to the projected future earnings. It is an estimate based on conjecture.
WHAT YOU NEED TO KNOW
What each of these measures of PE has in common is this. Each is a measurement of value. Each one translates into the amount of money that you are going to pay for a given stock, based on earnings, if you choose to purchase it today. So for a stock that has a PE of 15, you are willing to pay $15 for every $1 of earnings.
By the same token, a company like Chipotle (CMG) currently has a PE ratio of 57. An investor here will have to ask the question: "Do I think it is a good investment to buy a company when I will be paying $57 in stock price for every dollar of earnings?"
HERE'S WHAT I THINK
In and of itself, the PE Ratio is not going to answer that question for you. The PE Ratio is just one measure in the criteria that most investors use when looking for opportunities in the market. You have to go much further than PE to discover what the real value of a company is.
Now, I want to make it perfectly clear that PE is just one measure of a stock's value. There are many others. However, it is a good place to start, in terms of paring down a list of companies that you are interested in.
If you just ran a screen with stocks that have a PE Ratio of less than 10, you will get a list of companies that may or may not be worthy of your investments. Here are the results from that screen, selecting companies in the S&P 500, with all three PE Ratios less than 10:
WHAT YOU NEED TO DO
This list of 30 companies represent only stocks that currently meet the very limited criteria of PE Ratio. There are three companies in this list that do not pay dividends. The rest, pay a dividend of varying yields.
In and of itself, this list does nothing more than give you a starting point for further investigation. Depending on your personal style and strategy of investing, these companies may or may not have interest to you.
What you need to know is this. These companies are selling at a discount to earnings. Like purchasing a shirt on sale, these companies are on sale. The question is: "Why?"
This is where it gets a little tricky. There are a multitude of criteria that investors use to help them decide which companies they want to invest in. For some, it's the dividend yield and the dividend growth rate. For others, its the Debt-to-Equity Ratio. For others it's Free Cash Flow. And for some it is Return on Equity.
Whatever criteria you use to select your investment opportunities, you always need to consider your basic strategy and to stay in the place that makes you the most comfortable.
PEs however, are an important first stop in making stock selections for any portfolio and in my opinion, you don't want to rule PE out as something that is unimportant or outdated.
While some might argue that because of a specific metric, "XYZ" stock is a bargain at 60 times earnings, unless you like taking risk, you might want to look in a different place.