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Given the high returns that low PE ratio stocks earn, should you rush out and buy such stocks? While such a portfolio may include a number of undervalued companies, it may also contain other less desirable companies for several reasons. First, not all earnings are of equal quality. In recent years, some firms have used accounting sleight of hand and one-time income to report higher earnings. You would expect these firms to trade at lower price-earnings ratios than other firms. Second, even if the earnings are not skewed by accounting choices, the earnings can be volatile and the low PE ratio may reflect this higher risk associated with investing in a stock. Third, a low PE ratio can also indicate that a firm's growth prospects have run out. Consequently, it could be a poor investment.

Table 3.4. Stocks with PE Ratios Less Than 10: United States—October 2002
Acclaim EntertainmentENT TECH7.453.885.73Kroger CoGROCERY9.709.707.87
AES CorpPOWER0.700.701.31Lafarge No AmericaCEMENT8.597.537.70
Aftermarket TechAUTO-OEM8.146.446.29LandAmerica Finl GroupFINANCL6.295.796.52
Allegheny EnergyUTILEAST1.221.742.68Lennar CorpHOMEBILD8.547.986.65
Allied WasteENVIRONM6.936.816.57M.D.C. HoldingsHOMEBILD6.226.276.15
Allmerica FinancialINSPRPTY2.574.913.23Magna Int'l 'A'AUTO-OEM8.518.428.52
Amer AxleAUTO-OEM9.537.597.31Marathon Oil CorpOILINTEG5.128.079.41
Aquila IncUTILCENT2.835.556.81May Dept StoresRETAIL9.609.609.80
Argosy GamingHOTELGAM8.186.307.16McDermott Int'lDIVERSIF5.695.693.59
Ashland IncOILINTEG4.278.767.59Metro One TelecomINDUSRV8.027.913.94
Astoria FinancialTHRIFT9.669.667.88MGIC InvestmentFINANCL6.966.816.34
Bally Total FitnessRECREATE2.752.843.01MicroFinancial IncFINANCL1.341.343.17
Beverly EnterprisesMEDSERV4.754.844.30Mirant CorpPOWER0.680.771.33
Building MaterialsBUILDSUP6.166.167.02Nash Finch CoFOODWHOL7.526.005.73
CAE IncDEFENSE5.765.766.60Nationwide Fin'lINSLIFE8.028.207.77
Calpine CorpPOWER1.161.402.31Nautilus Group IncRETAILSP7.175.495.18
Can. Imperial BankBANKCAN7.627.628.55New Century FinancialFINANCL9.944.213.44
Centex CorpHOMEBILD7.026.805.61Petroleo Brasileiro ADROILINTEG2.972.973.23
Chromcraft RevingtonFURNITUR7.117.476.84Petroleum Geo ADROILFIELD3.153.652.35
Cleco CorpUTILCENT7.346.817.87Philip MorrisTOBACCO9.598.589.17
CMS Energy CorpUTILCENT5.926.905.48Pinnacle West CapitalUTILWEST6.676.678.23
CryoLife IncMEDSUPPL6.016.014.19PMI GroupINSPRPTY8.718.717.29
Del Monte FoodsFOODPROC8.238.238.47PNM ResourcesUTILWEST4.976.609.60
Dixie GroupTEXTILE0.009.336.22Precision CastpartsDEFENSE5.445.416.55
Dominion Homes IncHOMEBILD7.145.045.55Public Serv EnterpriseUTILEAST5.626.496.01
Downey FinancialTHRIFT8.469.149.76Pulte HomesHOMEBILD8.497.106.20
DPL IncUTILCENT8.348.349.22Quaker FabricTEXTILE9.167.237.34
Duke EnergyUTILEAST7.788.277.65Quanta ServicesINDUSRV1.891.894.21
Dura Automotive 'A'AUTO-OEM5.995.903.62R.J. Reynolds TobaccoTOBACCO8.035.995.65
Dynegy Inc 'A'GASDIVRS0.460.563.87Radian Group IncFINANCL9.398.467.80
El Paso ElectricUTILWEST8.178.179.43Radiologix IncMEDSERV7.356.677.77
Electronic Data SysSOFTWARE5.845.144.37Republic Bancorp Inc KY Cl ABANK9.878.649.09
ENDESA ADRFGNEUTIL8.139.778.01Ryland GroupHOMEBILD7.216.266.87
ePlus IncINTERNET7.707.877.80Salton IncHOUSEPRD2.762.766.52
Federated Dept StoresRETAIL9.629.058.63Sears RoebuckRETAIL7.777.134.69
Fidelity Nat'l Fin'lFINANCL9.097.266.48Shaw GroupMETALFAB8.906.315.84
First Amer CorpFINANCL9.038.119.55Sola Int'lMEDSUPPL6.957.279.23
FirstFed Fin'l-CATHRIFT8.908.969.28Sprint CorpTELESERV8.478.478.85
Fleming CosFOODWHOL2.472.472.23Stillwater MiningGOLDSILV3.253.255.28
Flowserve CorpMACHINE8.786.885.31SUPERVALU INCFOODWHOL9.028.197.03
Foot LockerRETAILSP9.488.948.53TECO EnergyUTILEAST5.715.715.79
Gadzooks IncRETAILSP7.586.747.02Telefonos de Mexico ADRTELEFGN8.048.048.03
Genesco IncSHOE7.157.619.02Toll BrothersHOMEBILD6.516.186.66
Gerber ScientificINSTRMNT9.299.295.69Tommy HilfigerAPPAREL5.766.675.50
Goodrich CorpDEFENSE5.925.926.78Trans World EntertainRETAILSP7.507.507.52
Greater Bay BancorpBANK8.246.336.45Triumph Group IncINSTRMNT8.418.927.94
Green Mountain PwrUTILEAST7.787.789.43TXU CorpUTILCENT3.583.192.70
Group 1 AutomotiveRETAILSP8.898.896.93Tyco Int'l LtdDIVERSIF5.015.007.52
Gulfmark OffshoreMARITIME7.099.888.78UIL HoldingsUTILEAST7.087.888.35
Handleman CoRECREATE5.875.785.74United RentalsMACHINE3.963.963.11
Haverty FurnitureRETAILSP9.708.409.45Universal Amern Finl CorpINSLIFE8.999.768.31
HEALTHSOUTH CorpMEDSERV4.414.413.84Universal CorpTOBACCO8.358.358.62
Helen of Troy LtdCOSMETIC9.019.017.27URS CorpINDUSRV7.376.247.37
Household Int'lFINANCL6.597.064.52Warrantech CorpINDUSRV7.595.613.00
Imperial Chem ADRCHEMDIV7.017.018.97Westar EnergyUTILCENT0.003.349.43
InterTAN IncRETAILSP9.009.008.59Westpoint StevensTEXTILE0.005.291.60
KB HomeHOMEBILD8.517.136.32Whirlpool CorpAPPLIANC8.417.497.13
     World AcceptanceFINANCL6.456.106.98

Risk and PE Ratios

In the earlier section, you compared the returns of stocks with low price-earnings ratios to other stocks in the market over a long period and concluded that low PE stocks do earn higher returns on average. It is possible, however, that these stocks are riskier than average and that the extra return is just fair compensation for the additional risk. The simplest measure of risk you could consider is stock price volatility, measured with a standard deviation in stock prices over a prior period. Consider the portfolio of low PE stocks that you constructed at the end of the last section. The standard deviation in stock prices was computed for each stock in the portfolio. In Figure 3.7, the average standard deviation for the low PE portfolio is compared with the standard deviation of all stocks in the market for a three-year and a five-year period.

Figure 3.7. Standard Deviation in Stock Prices

Data from Value Line. The average annualized standard deviation in weekly stock prices over three and five years is reported.

Surprisingly, the lowest PE stocks, are, on average, less volatile than the highest PE stocks, though some stocks in the low PE portfolio are more volatile than average.

Some studies try to control for risk by estimating excess returns that adjust for risk. To do so, though, they have to use a risk-and-return model, which measures the risk in investments and evaluates their expected returns, given the measured risk. For instance, some researchers have used the capital asset pricing model and estimated the betas of low PE and high PE portfolios. They come to the same conclusion that the analyses that do not adjust for risk come to: that low PE ratio stocks earn much higher returns, after adjusting for beta risk, than do high PE ratio stocks. Consequently, the beta was computed for each of the stocks in the low PE portfolio, and the average was contrasted for the portfolio with the average for all other stocks, as shown in Figure 3.8.

Figure 3.8. Betas of Low PE Ratio Companies

Data from Value Line. This is the average beta (computed over 5 years of weekly returns) across stocks in the portfolio.

On this measure of risk as well, the low PE ratio portfolio fares well, with the average beta of low PE stocks being lower than the average PE for the rest of the market.

While the average beta and standard deviation of the low PE portfolio is lower than the average for the rest of the market, it is still prudent to screen stocks in the portfolio for risk. You could, for instance, eliminate all firms that would fall in the top quintile of listed stocks in terms of risk, beta or standard deviation. Looking at stocks listed in October 2002, this would have yielded cutoff values of 1.25 for beta and 80% for standard deviation. Removing firms with betas greater than 1.25 or standard deviations that exceed 80% from the sample reduces the number of stocks in the portfolio from 115 to 91. Table 3.5 lists the 24 firms removed as a result of failing the risk screen.

Table 3.5. Firms Removed from Low PE Portfolio: Risk Test
Beverly EnterprisesMedserv1.2775.58%
Allmerica FinancialInsprpty1.3149.50%
Precision CastpartsDefense1.3352.58%
Federated Dept StoresRetail1.3446.00%
Telefonos de Mexico ADRTelefgn1.443.74%
Petroleum Geo ADROilfield1.474.49%
Shaw GroupMetalfab1.4469.20%
United RentalsMachine1.6858.13%
Flowserve CorpMachine1.7154.84%
InterTAN IncRetailsp1.7361.29%
Dynegy Inc 'A'Gasdivrs1.7877.24%
Tyco Int'l LtdDiversif1.8760.57%
Stillwater MiningGoldsilv1.8765.61%
Salton IncHouseprd2.0573.57%
CryoLife IncMedsuppl−0.3481.08%
Dura Automotive 'A'Auto-oem2.3581.56%
Quanta ServicesIndusrv2.4882.67%
Calpine CorpPower1.9585.18%
Metro One TelecomIndusrv1.7486.70%
AES CorpPower2.2689.64%
Aftermarket TechAuto-oem1.02100.83%
ePlus IncInternet1.57113.77%
Westpoint StevensTextile0.74126.22%
Acclaim EntertainmentEnt tech3.33237.57%

Note that firms are required to pass both risk tests. Thus, firms that have betas less than 1.25 (such as Westpoint Stevens) but standard deviations greater than 80% are eliminated from the portfolio.

Low Growth and PE Ratios

One reason for a low PE ratio for a stock would be low expected growth. Many low PE ratio companies are in mature businesses for which the potential for growth is minimal. If you invest in stocks with low PE ratios, you run the risk of holding stocks with anemic or even negative growth rates. As an investor, therefore, you have to consider whether the tradeoff of a lower PE ratio for lower growth works in your favor.

As with risk, growth can be measured in many ways. You could look at growth in earnings over the last few quarters or years, but that would be backward looking. There are stocks whose earnings have stagnated over the last few years that may be ripe for high growth, just as there are stocks whose earnings have gone up sharply in the last few years that have little or no expected growth in the future. It is to avoid this peering into the past that investors often prefer to focus on expected growth in earnings in the future. Estimates of this growth rate are available for different forecast periods from analysts and are often averaged and summarized (across analysts) by services such as I/B/E/S or Zacks. The average past and expected growth rates in earnings per share for firms in the low PE portfolio are computed and compared in Figure 3.9 to the same statistics for the rest of the market in October 2002.

Figure 3.9. Growth Rates: Lowest PE Stocks vs. Other Stocks

Data from Value Line. The projected sales and EPS growth for the next five years comes from analyst forecasts.

The earnings of the lowest PE ratio stocks have grown faster than the earnings of other stocks if you look back in time (one year or five years). However, the projected growth in both sales and earnings is much lower for the low PE ratio stocks, indicating that this may be a potential problem with the portfolio and a partial explanation for why these stocks trade at lower values. Consequently, you should consider screening the portfolio of low PE stocks for those with low or negative growth rates. Introducing a minimum expected growth rate of 10% in expected earnings reduces the sample of low PE stocks by 52 firms. A minimum expected growth rate of 5% would reduce the sample by 27 firms. If you believe that analyst estimates tend to be too optimistic and introduce an additional constraint that historical growth in earnings would also have to exceed 5%, you would lose another 18 firms from the sample. Table 3.6 summarizes the 41 firms that are eliminated by introduction of a dual growth constraint—a historical earnings per share growth rate that exceeds 5% and analyst projected earnings per share growth greater than 5%.

Table 3.6. Firms Removed from Low PE Portfolio: Growth Test
Aquila IncILA–10.00%7.00%
CMS Energy CorpCMS–4.00%–0.50%
PNM ResourcesPNM–1.50%11.50%
UIL HoldingsUIL–1.00%4.00%
Trans World EntertainTWMC–0.50%0.00%
Stillwater MiningSWC0.50%0.00%
Allegheny EnergyAYE1.00%8.50%
Allmerica FinancialAFC1.00%11.50%
Marathon Oil CorpMRO1.00%28.00%
Imperial Chem ADRICI1.50%–3.50%
Pinnacle West CapitalPNW2.00%9.00%
El Paso ElectricEE2.50%15.50%
Salton IncSFP2.50%72.50%
Calpine CorpCPN3.50%0.00%
Sprint CorpFON3.50%0.00%
Ashland IncASH3.50%14.50%
Universal CorpUVV3.50%15.50%
Westpoint StevensWXS4.00%0.00%
Quanta ServicesPWR4.50%0.00%
TECO EnergyTE4.50%4.50%
Lafarge No. AmericaLAF4.50%17.50%
Del Monte FoodsDLM5.00%0.00%
May Dept. StoresMAY5.00%6.00%
Tommy HilfigerTOM5.00%15.00%
Precision CastpartsPCP5.00%20.50%
AES CorpAES5.00%28.50%
Westar EnergyWR16.00%–25.50%
Green Mountain PwrGMP20.50%–19.50%
Petroleum Geo ADRPGO15.00%–14.50%
Beverly EnterprisesBEV9.50%–12.50%
Gerber ScientificGRB14.00%–9.50%
Quaker FabricQFAB18.17%–5.50%
Sola Int'lSOL6.00%–3.50%
Nash Finch CoNAFC17.50%-–3.50%
Aftermarket TechATAC8.50%2.00%
TXU CorpTXU9.50%2.00%
Electronic Data SysEDS13.00%2.50%
Chromcraft RevingtonCRC13.00%4.00%
Gadzooks IncGADZ18.33%5.00%

Earnings Quality and PE Ratios

With their focus on earnings per share, PE ratios put you at the mercy of the accountants who measure these earnings. If you assumed that accountants make mistakes but that they work within established accounting standards to estimate earnings without bias, you would be able to use PE ratios without qualms. In the aftermath of the accounting scandals of recent years, you could argue that accounting earnings are susceptible to manipulation. If earnings are high not because of a firm's operating efficiency but because of one-time items such as gains from divestiture or questionable items such as income from pension funds, you should discount these earnings more (leading to lower PE ratios).

How can you screen stocks to eliminate those with questionable earnings? It is difficult to do, since you learn of troubles after they occur. You could, however, look for clues that have historically accompanied earnings manipulation. One would be frequent earnings restatements by firms, especially when such restatements disproportionately reduce earnings.[7] Another would be the repeated use of one-time charges to reduce earnings. For example, Xerox had large one-time charges that reduced or eliminated earnings every single financial year during the 1990s. A third is a disconnect between revenue growth and earnings growth. While it is entirely possible for firms to report high earnings growth when revenue growth is low for a year or two, it is difficult to see how any firms can continue to grow earnings 20% a year, year after year, if their revenues growth is only 5% a year.

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