The Price/Earnings ratio is how much money you are paying for $1 of the company's earnings. So if a company is reporting a profit of $2 per share, and the stock is selling for $20 per share, the P/E is 10. In other words you are paying ten-times earnings.
P/E Ratio = Price Per Share / Annual Earnings per Share
A favourite tool of the contrarian is the price/earnings ratio (P/E), which is calculated by dividing the current share price in cents by the company’s earnings per share, or EPS. Thankfully, the historic P/E on stocks is readily available, so you don't have to manually do this calculation yourself.
The P/E ratio is rather useless on its own, but is a handy comparison tool. You can use it to compare one company against its peers, to the overall market, or sector, as well as to track historic performance.
Let's say that one company (Company A) has a P/E of 12 and another company in the same industry (Company B) sports a P/E of 20. For every $1 of current earnings, the investor is effectively paying $12 a share for Company A and $20 a share for Company B.
It's clear that Company A is cheaper than Company B because for every $1 of earnings, you're paying $12 a share instead of $20.
Contrarian investors use this as a guide for finding stocks that are going cheap. They particularly like stocks that are trading on a low P/E relative to their peers and the overall market.
But does that mean that Company A is a better buy than Company B?
As we all know, earnings are the basic ingredients of share price growth, and the best stocks to buy are those exhibiting a trend of increasing earnings (we like to see earnings growth for five years or longer). Remember, earnings refer to “net profits” and not revenue.
When investors spot a company with a trend of increasing earnings, they get excited and buy shares. As more shares are purchased, the share price is bid up, and so is the P/E ratio (since the current share price is the numerator in the ratio). The more popular the stock, the higher its P/E.
So Company B could in fact be a better buy than Company A if its earnings are growing at a faster pace.
There are times however when markets get out of wack. External shocks such as the recent financial crisis send share prices into a spin, and stocks that were once expensive (on a P/E) basis can be suddenly looking pretty darn cheap.
It's times like these that contrarian or value investors come to the fore. With their toolkit in hand, bargain hunters set to work.
A bargain means that you are getting something that should cost $10, for $5. You buy a leather couch on special for $2,000 that a week prior was holding a price tag of $4,000. This is what most of us call a true bargain without thinking too much about it.
But just because the coach was priced at $4,000 the week prior, doesn’t necessarily mean that it's a bargain at $2,000. (It could be old stock, its design could be going out of fashion).
Likewise, just because your favourite stock was trading at a P/E of 10 many months ago, doesn't necessarily mean that it's a steal at 6 today. Basically you have to consider whether the fundamentals have changed.
For example, as consumers tighten their purse strings, will the company struggle to sell its goods and services? If the company has a lot of debt on its books, will it battle to get funding? If it's an importing company, will the fall in the AUD/USD impact its sales?
Sometimes a fall in the P/E can be justified, sometimes not. And getting this right is the true test of whether a contrarian investor spots a bargain or not. .
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