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Chapter 3. This Stock Is So Cheap! the Low Price-Earnings Story

Chapter 3. This Stock Is So Cheap! the Low Price-Earnings Story

Graham's Disciple

Jeremy was a value investor, and he had disdain for investors who chased growth stocks and paid exorbitant prices for them. Reading Forbes one day, Jeremy was excited to see the results of an academic study that showed that you could beat the market by buying stocks with low price-earnings ratios, an approach highly favored by other value investors. Getting on Yahoo! Finance, Jeremy looked for stocks that traded at price-earnings ratios less than 8 (a number he had heard on CNBC was a good rule of thumb to use for low PE stocks) and was surprised to find dozens. Not having the money to invest in all of them, he picked the first 20 stocks and bought them.

In the year after his investments, instead of the steady stream of great returns that the academic study had promised, Jeremy found himself badly trailing the market. All his friends who had bought technology stocks were doing much better than he, and they mocked him. Taking a closer look at his depleted portfolio, Jeremy found that instead of the safe, solid companies that he had expected to hold, many of his companies were small risky companies with wide swings in earnings. He also discovered that the stocks he picked were unusually prone to reporting accounting irregularities and scandals. Disillusioned, Jeremy decided that value investing was not all it was made out to be and shifted all of his money into a high growth mutual fund.

Moral: A stock that trades at a low PE is not always cheap, and the long term can be a long time coming.


For decades investors have used price-earnings ratios (PEs) as a measure of how expensive or cheap a stock is. A stock that trades at a low multiple of earnings is often characterized as cheap, and investment advisors and analysts have developed rules of thumb over time. Some analysts use absolute measures—for instance, stocks that trade at less than 8 times earnings are considered cheap—whereas other analysts use relative measures, for example, stocks that trade at less than half the price-earnings ratio of the market are cheap. In some cases, the comparison is to the market, and in other cases it is to the sector in which the firm operates.

In this chapter, you consider whether price-earnings ratios are good indicators of value and whether a strategy of buying stocks with low price-earnings ratios generates high returns. As you will see, a stock with a low price-earnings ratio may not be undervalued and strategies that focus on just price-earnings ratios may fail because they ignore the growth potential and risk in a firm. A firm that trades at a low price-earnings ratio because it has little or no prospects for growth in the future and is exposed to a great deal of risk is not a bargain.

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