Why P/E Ratio Matters

by: Brandon Fredrickson

The Price to Earnings ratio is a simple measure that takes the price a stock is trading at over the year's 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 ratios 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. Let's 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, pushing 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 portfolio. 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 important 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.