The First Cut: Low P/E Relative

    by John Bajkowski

    The First Cut: Low P/E Relative Splash image

    The price-earnings ratio (P/E), or earnings multiple, is one of the most popular measures of company value. Value investors analyze companies with low price-earnings ratios hoping to find stocks mispriced because of market neglect or overreaction to bad news.

    The P/E relative is often used to judge whether a company’s price-earnings ratio has strayed too far from its normal range.

    Dividing a company’s price-earnings ratio by the market ratio gives you the P/E relative; a P/E relative of 1.0 indicates that the P/E for the company and market are the same. One would expect a company with prospects better than the market to have a higher price-earnings ratio than the market and a P/E relative above 1.0.

    Many different market averages can be used; the median price-earnings ratio for all U.S.-traded stocks was employed by the First Cut. Averaging the P/E relative over time provides a sense for whether a stock typically trades at a discount or premium to other stocks.

    The exchange-listed, domestic companies passing the First Cut have the lowest current P/E relative versus their five-year average. To guard against companies anticipated to have a near-term earnings decrease, the First Cut screen also looks for companies projected to increase earnings per share for the current and subsequent fiscal year. The table presents the current and historical year-by-year price-earnings ratios to gain a feel for valuation levels over time. All firms passing the screen were required to have a 52-week relative strength rank of 50% or higher—highlighting potentially undervalued stocks with above-average price strength.

    The P/E relative approach assumes that the firm has not fundamentally changed over time. A careful evaluation of each firm’s relative P/E must be undertaken to determine if it represents a reasonable relationship to the market going forward.

    —John Bajkowski
    AAII Vice President, Senior Financial Analyst


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