Strategic Investing: Leveraging Price-Earnings Ratios for Profitable Returns and Growth
One of the most often used metrics for determining a company’s worth is the price-earnings (P/E) ratio, also known as the earnings multiple. It is calculated by dividing the current stock price by the trailing 12-month earnings per share. It is so keenly watched because it links the actual recent earnings success of the firm to the market’s anticipation of future company performance, which is ingrained in the price component of the equation. Investors are prepared to pay a larger multiple of current earnings in exchange for the prospect of future earnings in proportion to their expectations.
There are models to help gauge if a company’s price-earnings ratio is reasonable. The relative price-earnings ratio approach looks at the relationship of a stock’s price-earnings ratio to the price-earnings ratio of the overall market or the company’s industry.
AAII’s P/E Relative screen has outperformed the S&P 500 index since inception. From January 1998 through March 2024, the screen has generated a compound annual price gain of 13.8% while the S&P 500 has an annual price return of 6.3% over the same period. On average, the screen has 36 passing stocks, with an average turnover of 21.3%.
The Price-Earnings Relative
The price-earnings relative is determined by dividing a company’s price-earnings ratio by that of the market. Based on relative growth and risk expectations, companies trade at multiples greater or smaller than that of the market multiple. One would expect a company with prospects better than the market, or with lower risk, or both, to have a higher price-earnings ratio than the market. Comparing a firm to its industry is an equally useful technique that has the benefit of isolating interesting candidates within a specific industry.
Changes in the relative levels of the price-earnings ratio may signal that the market, for whatever reason, is changing its expectations about the future earnings potential of a firm or not paying attention and mispricing the security. It may also signal that a short-term change has already occurred or is expected to occur. However, the price-earnings relative valuation model assumes that the long-term growth and risk profile of the firm has not fundamentally changed over time. A careful evaluation of each firm’s relative price-earnings ratio must be undertaken before investing to determine if it represents a reasonable relationship to the market going forward.
A price-earnings relative average above 1.00 indicates that a company’s price-earnings ratio is typically above the market’s price-earnings ratio, while a price-earnings relative average below 1.00 signals that a company’s price-earnings ratio tends to be lower than that of the market. Changes in the price-earnings relatives compared to average levels may indicate an incorrect valuation.
Calculating Price-Earnings Relative
AAII’s stock screening program and stock database Stock Investor Pro has filtering criteria that allow you to screen using the price-earnings relative, along with the various other measures, such as the price-earnings relative valuation.
To calculate the price-earnings relative, you need two things:
- The current market price-earnings ratio
- The five-year average price-earnings relative for the stock you are examining
To get the current market price-earnings ratio, you can utilize Stock Investor Pro or another reputable source that publishes market data. The complete domestic stock market universe within Stock Investor Pro was used to determine median price-earnings ratios for the last five years along with the current median price-earnings ratio. Multiplying the market’s current price-earnings ratio by the company’s price-earnings relative provides an adjusted price-earnings ratio that can be used to calculate a simple fair market valuation.
Dividing the current price by the valuation provides a useful screening measure. A value of 1.00, or 100%, indicates that the valuation and current stock price are equal. Figures above 100% may point to stock prices above valuation estimates, while figures below 100% may highlight undervalued companies.
Screening for Undervalued Stocks Based on P/E Relatives
Stock Investor Pro is used to perform the screen. To ensure reasonable liquidity, our first screen looks for stocks traded on the Nasdaq, the New York Stock Exchange (NYSE) and the NYSE American Exchange. We also eliminate American depositary receipts (ADRs), which are foreign companies traded on U.S. exchanges.
The next set of filters requires that firms have five years of data and that earnings per share are positive for each of the last five years. A price-earnings ratio can only be calculated with positive earnings per share.
Beyond negative earnings, which lead to meaningless price-earnings ratios, unusually low earnings may also throw off standard price-earnings ratio screens. Short-term drops in earnings due to incidents such as extraordinary events — or, in some cases, even recessions — may lead to unusually high price-earnings ratios. As long as the market interprets the earnings decrease as temporary, the stock price may not fall as dramatically as the earnings, resulting in a high price-earnings ratio. Because the average price-earnings relative model relies on a normal situation, these “outlier” price-earnings ratios should be excluded.
When performing a hands-on evaluation, you can manually exclude years with negative earnings or unusually high price-earnings ratios. However, when screening a large universe of stocks, it is best to establish criteria that try to eliminate companies with extreme price-earnings ratios. For our screen, companies with ratios above 100 for any of the last five fiscal years are excluded. If you want to be more conservative, a tighter requirement — such as ratios above 40 or 50 — might be specified.
We do not screen for minimum historical or expected growth rates. It is important to remember that the growth rate is a raw growth figure that does not necessarily divulge any change in trend or indicate the variability of earnings. The easiest and most direct way to judge earnings is to examine the earnings directly year by year, looking for stability and accelerating growth. As a basic screen, positive earnings per share from continuing operations for the most recent 12 months and each of the last five years are required. Screens that are more stringent would require increases in each of the last five years or even an increase in the year-to-year growth rate for each of the last five years.
It is important to look at factors leading to the growth and determine if the growth is sustainable. When examining a firm’s earnings patterns, it is necessary to carefully read both quarterly and annual reports, which can clue you in to possible explanations of the earnings growth pattern. Was a significant portion of the earnings growth achieved through acquisition or internal growth? Did earnings growth from franchises come from increases in same-store sales or the opening of new stores? Did currency translations impact earnings? Are competitive conditions changing within the industry? Are margins increasing or decreasing?
The table of passing companies includes stocks with current prices below their valuation estimates computed with trailing earnings per share and five-year average price-earnings relatives. The stocks are ranked on the price as a percent of price-earnings relative valuation. To arrive at the valuation, the earnings per share for the last 12 months was multiplied by the adjusted price-earnings ratio.
Current Passing Companies
Below is a table containing the top 25 stocks currently passing AAII’s P/E Relative screen, ranked on price-earnings relative valuation as a percentage of price.
Stocks Passing the P/E Relative Screen (Ranked by P/E Relative Valuation as % of Price)
Investors often look for a catalyst to help attract attention to a company and boost its stock price. The stock prices of many attractively priced stocks often languish until investors find a reason to reevaluate the prospects of the firm or its industry. Upward earnings revisions and positive earnings surprises are events that make investors take notice of a company. Revisions to earnings estimates lead to price adjustments. When earnings estimates are revised significantly, stocks tend to have above-average performance. Stock prices of firms with downward revisions tend to have below-average performance after the adjustment. Changes in estimates reflect changes in expectations of future performance. For our screen, we require upward revisions to the current year and next year’s earnings over the last month.
Price momentum is often used as a signal that the market has recognized that the stock price is reacting to either proven performance or an increase in expectations. Investors look for stock price performance superior to that of other stocks with the belief that the rising price will attract other investors who will drive up the price even more. The current market price as a percentage of the 52-week high price is a popular measure of price strength and momentum. If a firm’s stock price continues to be strong, it should be trading near its 52-week high.
Conclusion
Screening for stocks by looking at price-earnings ratios can help highlight firms that have fallen out of favor. Price-earnings relatives help to establish benchmark comparisons for identifying firms that have deviated from their normal valuation level with the critical assumption that nothing fundamental to the company, industry or market has changed significantly. The analysis can highlight companies worthy of further analysis, given the expectation that they will move back to their typical levels.
In constructing screening criteria, you may wish to include a number of conditioning criteria that help indicate items such as the future earnings potential of the firm, the financial strength of the firm and the strength of the firm within its industry. Investing in low price-earnings stocks can be rewarding, but caution is required.
Simply looking at historical price-earnings ratios, stock prices and earnings is informative. The price-earnings approach is far from a secret and will only be successful if the inputs and your expectations are proven to be well-founded.
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The stocks meeting the criteria of the approach do not represent a “recommended” or “buy” list. It is important to perform due diligence.
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