If you believe you can make good money by selecting stocks with low P/Es solely, dream on. If it were that easy, there will be no poor folks. However, buying fundamentally sound companies would reduce the risk and improve the chance of its appreciation.
P/E is the most misunderstood indicator. To me, it is the most useful one among all metrics if it is properly used. Earnings are the key to stock appreciation and P/E measures its value. To illustrate on P/E, you pay a million for a hot-dog cart in NYC. Even if its earnings increase year after year, you will never recoup your investment as you have paid too much even for a good business.
“Buy stocks with P/E below 15 and earnings positive” is not true in many cases. P/E growth (PEG) should be considered at least as a prospect of the company. Many retailers were destroyed by Amazon and many newspapers were destroyed by Facebook and Google. Which sector do you want to buy: the sector in up trending or the dying sector even with a better P/E?
Most old books on value are based on old industries that are no longer applicable in today's market. Read these books but ask the above question.
Better definition
P/E should be inverted as E/P, which is termed as Earnings Yield. Earnings Yield is easy to be compared and understood. It takes care of negative earnings for screening stocks and ranking (comparing stocks with the better P/E first). If you sort P/E in ascending order, your order will be wrong with the negative earnings but right with E/P.
It is usually compared to a 10-year Treasury bill yield (or 30 years) or a CD rate. If the stock has 5% earnings yield and your one-year CD is 1%, then it beats the CD by 4% in absolute numbers and four times better. However, the CD is virtually risk free (with deposit amount limits in most banks). Earning yield is an estimated guess and it may not materialize.
Many ways to predict E/P
· Based on the last 12 months. Project it to the Forward E/P. It is also called the last twelve month E/P.
· Based on analysts' educated guesses. Guesses may not materialize. Based on my experience, the expected usually predicts better than the one based on the last 12 months. This is the one I use most and many investing subscriptions provide this Forward P/E (same as the Expected P/E) or expected E/P.
Usually I do not trust the analyst's opinions due to their conflict of interest. However, the earnings estimate is my exception.
· Based on the last month or the last quarter. Latest information could be better for predictions. However, they are not good for seasonal businesses such as the retail where most sales are done during the Christmas season.
· Besides the Pow PE described later, I take the average of the earnings yield EY as:
The Avg. EY = (EY from the last twelve month + Expected EY + EY from the current month of prior year) / 3
It averages out using figures from the past, the present and the future. If no one has used it, I claim shamelessly it is my original idea.
Best E/P could not be the best
Very high E/P could be signs of troubles ahead such as a lawsuit pending, fraud, etc. If you find companies E/P over 50%, it means two years' profits could be equal to the entire cost of the company! I can tell you right away that they probably smell fishy unless you believe that there is a free lunch in life.
However, from time to time, some bargains do exist due to certain conditions, or the Wall Street is just wrong about the company. I found one in my year-end screen and that gave me huge return. You need to find out whether they are bargains or traps. When the E/P is low (sometimes even negative) but is improving fast, it could mean big profits for you. Fundamentalists may miss this opportunity in the early stages due to the unfavorable E/P, but it could be the most profitable time to buy. Sometimes, it could be a turnaround.
During a recession, most good companies have a hard time in promoting new products as the consumers are thrifty. At the same time, it usually is the best time to develop products if they have enough cash to finance them. In this case, there will be no alarm even with negative earnings. The only alarm is when a company cannot meet the debt obligations.
Some companies can manipulate earnings via dirty tricks in accounting. It could make this year look really good, but it is harder or even impossible to continue the same trick for many years. Check out the footnotes in the financial statement.
E/P and PEG
For value investing, E/P is usually used and the higher the better. Watch out when it is extraordinarily high.
PEG (P/E growth) measures the rate of improving P/E.
PEG = (P/E) / Earnings Growth Rate
They have similar problem with P/E with negative earnings..
Which of the following two stocks do you want to buy based on their historical earning yields and earnings growth?
1. A stock that has a 10% earnings yield with no earnings growth.
2. A stock that has an 8% earnings yield with 50% earnings growth.
If the earnings growth continues, in next year the second stock should pay 12%, substantially better than the first stock. This is another reason we should use forward earnings rather than historical earnings.
PEG may give a low value for companies that pay high dividends. To correct it,
PEG = (P/E)/ (Earning Growth Rate + Dividend Yield)
When the general market favors growth stocks, weigh more on growth metrics including PEG. I claim no credit on the adjusted PEG.
Fundamental metrics
E/P is one of the metrics you should use but not exclusively. If the earning yield is high but the % of debt is high too, then a good bargain may not be as good as it appears to be.
Some other metrics may not be easily found in the financial statements such as the intangibles, insider buying, pension obligations, trade secrets, losing market share, brand name, customers' loyalty, etc. It is interesting that most metrics change its ability to predict from time to time.
P/E variations
There are other P/E variations like Shiller P/E (same as CAPE and PE10). Shiller P/E can also be used to track the current market valuation. It is controversial and its value is easily misinterpreted. Hence, use it as a reference only unless you understand all its issues. I prefer to use two year average of the P/E instead of 10 as I believe the market changes too much over a ten year span. Currently Shill P/E does not work that well as before. It is due to the excessive printing of money.
Compare a company's current P/E to its average P/E in the last 5 years. Also compare it to the average value of the companies in the same industry. The average P/E for high-tech companies is different from supermarkets for example. They are available from Fidelity.
P/E is more reliable for a group of stocks (SPY for example) instead of individual stocks which have too many other metrics and intangibles to deal with.
When you compare the total return of an ETF to a corresponding index, you need to add the respective dividends to the index to ensure a fair comparison of total returns. As of this writing, the S&P500 is paying about a 2% dividend.
EV/EBITDA is another way to measure the value of a company. This metric has its advantages and disadvantages over P/E. It includes other important data such as cash and debt. EBITDA/EV is equivalent to E/P including other mentioned metrics. I prefer to use it over E/P. Some sites do not provide it if the earnings is negative. The disadvantage to me is it does not use expected earnings. This ratio can be found under Yahoo!Finance.
Garbage in, garbage out
I do not trust most financial statements from emerging countries especially the smaller companies. Watch out for fraudulent data. Most metrics can be manipulated. Recently I have a US stock that lost 18% in one day due to the SEC's investigation of its financial data.
The announced earnings may not be reflected in the financial statements that you use from the web. Ensure your data is up-to-date by checking the date of the financial statements. Seeking Alpha has transcripts for the earnings announcements that would save you a trip to attend the companies' quarterly meetings.
Sector and entire market
You can find the value of a sector using the P/E of an ETF for that sector. It is similar for the market. For example, use SPY (an ETF simulating the S&P 500 index). If it is lower than the average (15 to me), then most likely the market is good value and a buy signal. It is one of the many hints for market timing.
Where to use P/E
Each highlight of the following corresponds to one of my books. Click it for the description of the strategy.
My book on top-down approach starts with a safe market, then sector analysis, fundamental analysis, intangible analysis and optionally technical analysis. P/E is one of the many metrics in fundamental analysis.
There are many styles of investing. In general, fundamental analysis is important when you hold the stock longer.
· P/E is important in Long-Term Swing, Dividend Investing, Retirees and Conservative Strategies.
· My max value is 20 and 25 for tech companies. I ignore it if they have high potential for appreciation that could be indicated by insider purchases. However, many unknown companies then had a P/E over 50. Tesla had a P/E over 1,000 at one time.
· P/E is moderately important in Short-Term Swing and Sector Rotation.
· P/E is the least important in Momentum Strategy and Day Trading.
Summary
Again, one metric should not dictate the reason to trade a stock. Compare the company P/E to its industry average and its own five-year average. In addition, many industries have cycles. If you buy it at the peak of the industry, the P/E may mislead you. Besides fundamental analysis, you need to consider intangible analysis and time the entry / exit point by using technical analysis. Intangible analysis evaluates information that cannot be summarized into numeric metrics such as a lawsuit pending.
True P/E
“EV/EBITDA” is available from Yahoo!Finance and other sources. The true EY is “1/Ture PE”. I call it “True” for the lack of a better term as it represents the financial situation of the company better. This could be the most important metric for many.
Earnings can be manipulated. For example, the company management can lower the P/E ratio by buying back its stocks. In this case the earnings per share is boosted but in reality there is no change in the company’s financial fundamentals. The true P/E takes into consideration of the reduced cash. EBITBA stands for “Earnings Before Interest, Taxes, Depreciation, and Amortization”.
Be careful when EV or “EBITDA” is negative. Most likely you should avoid the stocks with a negative EV.
Pow P/E
You should use the described “EV/EBITDA” and hence “Pow P/E” can be ignored. There are some cases that Pow P/E is better: 1. “EV/EBITDA” may not be available for reasons such as negative asset and 2. Use of Forward Earnings instead of Earnings based on the last twelve months. The following is an exercise on how I simulate it from Finviz.com with metrics that are readily available.
I modified P/E to take care of cash and debts. I use my last name due to being easier to distinguish from P/E and it has nothing to do with my ego.
Pow P/E = (P - Cash per Share + Debt per Share) / (Earning - Interest gained per share - Interest paid per share)
The following is my test from 1/2/2020 to 10/14/2020. RSP is similar to SPY except that the stocks in the S&P 500 index are equally weighed. EY (= E/P) is Expected Earnings Yield and there is no stocks with EY less than 0. DY is Dividend Yield. GPE is the growth of P/E. As in my book, I use annualized returns and dividends are not included. This test does not mean a lot, but it tells us what these metrics behave during this period, or it indicates Value is not a good metric in this period, and it may indicate momentum is better in this period. Most big winners start as small companies with high P/E (from 30 to 100). Many of them have important technologies or special systems that would change the world such as Microsoft, Facebook, Amazon and Walmart to name a few. Their sales have been increased substantially year after year.
Another example of not depending on low P/Es. Before the financial crisis in 2008, P/Es of most bank stocks had 10-year low. After they announced the earnings, P/Es of many of them surged to over 100 and the stock prices suffered losses of more than 80% within 12 months.
The following is very rough testing and there are many limitations in the database. However, the conclusion is quite convincing to me and some are opposite to the contrary beliefs. For example, I expected the higher EY the better, but not in this test.
|
|
Annualized Return |
Indicator |
Comment |
|
RSP 500 All |
-2% |
|
|
|
|
|
|
|
|
EY (top 10) |
-54% |
Bad |
Contrary |
|
GPE (top 10) |
-20% |
Bad |
Contrary |
|
|
|
|
|
|
Select All or top 100. |
|
|
|
|
DY = 0 |
16% |
Good |
|
|
DY (top 100) |
-19% |
Bad |
|
|
DY / 1 and 2 |
2% |
|
|
|
|
|
|
|
|
EY 3 to 4 |
15% |
Good |
Second best |
|
EY 2 to 3 |
6% |
Good |
Third best |
|
EY 1 to 2 |
31% |
Good |
Best |
|
EY 0 to 1 |
-39% |
Bad` |
|
I use some metrics from a service I subscribe that are not included here. Two major metrics of this subscription have a return of around 20%. Most subscriptions including the free Fidelity (to some extent) give you three composite scores: Total, Fundamental and Timing. I wish to check out the recent predictability of Fidelity’s Equity Summary Score if they have a historical database. Most of them take out the delisted and /or bankrupt companies in their databases.
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