HOW P/E RATIOS CAN LEAD YOU TO THE BEST BUYS

No single piece of financial information can disclose all of a stock’s mysteries. If you had to choose just one, though, the stock’s price/earnings ratio — its price divided by the company’s earnings per share — would tell you the most.

In particular, a P/E signals professional investors’ expectations about a company’s future earnings growth. The higher the P/E ratio, the more investors think the firm will grow over the next five years or so. Similarly, a relatively low P/E means that investors expect sluggish growth or at least a highly uncertain future.

Of course, the pros are sometimes wrong. The biggest profits come from finding a fast-growing company whose P/E is relatively low because other investors have not yet recognized its prospects. As earnings increase, the stock’s price is likely to move up even faster. The reason: once investors recognize the company’s growth potential, they will value its shares at a higher price/earnings ratio.

In effect, P/Es level the playing field, enabling investors to compare dissimilar companies and spot bargains. A simple way to think about this is to imagine that you are in a supermarket trying to pick a detergent. Faced with several brands in boxes of different sizes, you have to read the stickers on the shelf, which list the price per ounce for each brand, to make a fair comparison. P/E ratios work the same way by giving you a price per dollar of earnings.

In an effort to make P/Es even more useful, analysts have come up with endless variations (see the box below). The most frequently quoted P/E — the one in newspaper stock listings —is based on a stock’s current price and the earnings reported by the company for the past four quarters. This trailing P/E has the advantage of reflecting actual results, not estimates. Its disadvantage is that the earnings are out of date.

A better indication of a stock’s value is its current P/E, which steps into the near future. To arrive at this ratio, you add the stock’s reported results for the past six months to analysts’ estimates for the next two quarters. You can get earnings estimates from your broker or the Value Line Investment Survey.

The best P/E — especially for a fast-growing company — is often the projected P/E, a ratio that is based on analysts’ forecasts of earnings for the coming year.

To understand how these three P/E ratios differ, consider MCI Communications, a long-distance telephone company. Based on trailing earnings, MCI has a P/E of 15.5, compared with 14 for the average stock in Standard & Poor’s 500-stock index. But because of MCI’s fast profit growth, the company’s current P/E is 13, and its projected P/E for 1990 is only 10.2. If you looked just at the trailing P/E, you might conclude that MCI is high priced. In fact, many analysts consider the stock to be undervalued, given its projected growth rate, which is more than twice that of the average stock in the S&P 500.

In gauging whether a stock is a bargain, you need a benchmark. You can compare a stock’s P/E with the market’s P/E — as we did with MCI. Analysts sometimes use the S&P index of 400 industrial companies instead of the S&P 500 as a proxy for the market. (The S&P 400 is the 500 minus 100 transportation, financial and utility companies.)

A stock’s P/E divided by the P/E of the overall market is called the stock’s relative P/E. A quick way to scan for out-of-favor stocks that could be bargains is to look in a newspaper’s financial pages for shares with trailing P/Es below the trailing P/E of the S&P 500. Most stock pickers would consider a relative P/E of 0.8 or less a sign that a stock may be cheap. Be sure to check brokerage research. though, before you buy a low-P/E stock. Sometimes shares are cheap because the company has serious problems.

Since stocks in some industries typically have above-average or below-average P/Es, you may get a more accurate gauge of how expensive a particular stock is by comparing its P/ E with that of other stocks in the same industry (known as the industry’s P/E), or with the company’s own past P/E ratios (called the stock’s historical P/E). Take Ford, for example. The stock’s trailing P/E was recently 4.4, its current P/E 4.6. and its projected P/E 4.3. These low ratios, however, don’t necessarily indicate that the stock is a great bargain. Because automakers are cyclical companies whose earnings fluctuate considerably with changes in the economy, investors usually value them at P/Es less than half that of the overall market.

Comparing Ford’s P/E with that of the average auto stock — currently 4.8 — or with Ford’s own average P/E during the past five years — about 3.9—gives a better assessment. Ford now looks like a reasonable buy. according to some value-oriented stock pickers, but it is no bargain by historical standards.

An analysis of Ford’s various P/Es can also offer guidance if you are trying to time your purchase advantageously. The rise from the stock’s 4.4 trailing P/E to its 4.6 current P/E, followed by a decline back to a 4.3 projected P/E signals that analysts expect Ford’s earnings to dip during the next two quarters and then pick up again in the second half of 1990. You might therefore want to wait and try to buy it at a lower price during the next six months—just before the earnings upswing that analysts are forecasting.

This article is adapted from the AAII Journal ©1989 by John Markese, Director of research, American Association of Individual Investors, Chicago.