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Core of the Story

How do you determine that a stock is cheap? You could look at the price of a stock; but stock prices can be easily altered by changing the number of shares outstanding. You can halve your stock price (roughly) with a two-for-one stock split (by which you double the number of shares), but the stock does not get any cheaper. While some investors may fall for the pitch that a stock that trades for pennies is cheap, most investors are wary enough to see the trap. Dividing the price by the earnings is one way of leveling the playing field so that high-priced and low-priced stocks can be compared. The use of low PE ratios in investment strategies is widespread, and several justifications are offered for the practice:

  • Value investors buy low PE stocks. Investors in the value investing school have historically measured value by using the price-earnings ratio. Thus, when comparing across stocks, value investors view a stock that trades at five times earnings as cheaper than one that trades at ten times earnings.

  • A low PE stock is an attractive alternative to investing in bonds. For those investors who prefer to compare what they make on stocks to what they can make on bonds, there is another reason for looking for stocks with low price-earnings ratios. The earnings yield (which is the inverse of the price-earnings ratio, that is, the earnings per share divided by the current stock price) on these stocks is usually high relative to the yield on bonds. To illustrate, a stock with a PE ratio of 8 has an earnings yield of 12.5%, which may provide an attractive alternative to treasury bonds yielding only 4%.

  • Stocks that trade at low PE ratios relative to their peer group must be mispriced. Since price-earnings ratios vary across sectors, with stocks in some sectors consistently trading at lower PE ratios than stocks in other sectors, you could judge the value of a stock by comparing its PE ratio to the average PE ratio of stocks in the sector in which the firm operates. Thus, a technology stock that trades at 15 times earnings may be considered cheap because the average PE ratio for technology stocks is 22, whereas an electric utility that trades at 10 times earnings can be viewed as expensive because the average PE ratio for utilities is only 7.

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