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AAII How-To Fundamentals Stock Strategies

Incorporating the Price-Earnings Ratio Into Your Screening and Analysis

The price-earnings ratio is widely used as a valuation metric because of its simplicity. It embodies the market’s expectation of future company performance and relates it to actual, recent company performance.

by Matthew Bajkowski | September 2021

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A common refrain in investing advice is to buy low and sell high. This refrain is the center of a value approach to selecting stocks.

Getting deeper into the concept of value investing, the overall strategy has to do with a contrarian take on the efficiency of the stock market. Value investors seek stocks that are underappreciated or neglected by the majority of investors.

Although the market is generally efficient at pricing stocks, there are times when investors are oblivious to opportunities for gains. This is because the market is constantly changing, and investors’ decisions can be subject to their emotions.

Many investors pay too much for companies with the best prospects and react too negatively to companies with the weakest prospects. The practice of using an investment model highlights prospective investments and keeps emotions in check.

Following an investment strategy is a patience-trying process; value investing is no different. Strategies don’t always work over a short period, but patience is what makes strategies such as value investing work over the long term.

Periods of underperformance give way to periods of overperformance, historically. All boats rise with the tide; however, it is the boats at the bottom that rise the fastest and the most when the tide turns.

The P/E Ratio as a Valuation Metric

There is more than one metric investors can use to determine if a stock is trading at an attractive valuation. Common ones are the price-to-book-value (P/B) ratio, the price-earnings (P/E) ratio and the price-earnings to earnings growth (PEG) ratio. These ratios are also referred to as multiples.

The price-earnings ratio is the most ubiquitous metric used in the AAII stock screens. While there are many variations, it is calculated at its most basic level by dividing a stock’s current share price by its earnings over the trailing 12 months (TTM).

As a valuation metric, the price-earnings ratio is widely used because of its simplicity. It embodies the market’s expectation of future company performance through the price component and relates it to actual, recent company performance.

A high price-earnings ratio indicates that the market expects continued strong growth from a company; a low price-earnings ratio indicates that the market expects low growth from a company or that there is much uncertainty in the company’s historical growth.

For example, as of August 16, the company Logitech International SA (LOGI) trades with a price-earnings ratio of 17.6 based on a share price of $108.71 and trailing 12 months diluted continuing earnings per share (EPS) of $6.17. Referring to the price-earnings ratio as a multiple, the market believes Logitech is worth 17.6 times more than its earnings performance over the last 12 months.

The market expects more earnings growth from the company and is willing to pay a premium for it. The multiple that investors are willing to pay can expand or contract, though, as perceptions about the company’s prospects change. This is a normal process.

In contrast to value investors, growth investors are often willing to pay a high multiple of earnings with the expectation of the multiple expanding along with high earnings growth.

AAII Screens With P/E Ratio Filter

Go to www.aaii.com/stockideas/allstrategies and click on a screen’s name to read more about the criteria the screen follows.

Determining an Attractive Valuation

Is Logitech an attractive value investment with a price-earnings ratio of 17.6? To determine whether it is, the stock and its price-earnings ratio need to be assessed in relation to other factors.

First, you can compare Logitech’s individual price-earnings ratio to the median price-earnings ratio of the companies in its industry. The computer hardware industry’s median price-earnings ratio is 18.3 compared to Logitech’s 17.6. This indicates that Logitech is trading with an attractive valuation relative to other computer hardware companies, provided its prospects are similar to others in the industry.

You can also compare Logitech’s price-earnings ratio to that of all stocks. Relative to all stocks, Logitech’s price-earnings ratio of 17.6 comes in at a percentile rank of 47, meaning that 53% of all stocks are trading with a higher price-earnings ratio than Logitech.

Logitech is trading at an attractive valuation based on its price-earnings ratio relative to both its industry median and all available stocks. However, there is a key factor still missing from the valuation analysis. The price-earnings ratio does not inherently consider a company’s earnings growth rate.

As a metric of the market’s expectations for a stock relative to recent earnings, the price-earnings ratio looks at a snapshot of a company’s earnings at one point in time. It does not look at the rate of change in those earnings. Companies with higher earnings growth deserve to trade with higher earnings multiples.

Looking at Logitech’s price-earnings ratio relative to its earnings growth rate gives you the PEG ratio. It is calculated by dividing the price-earnings ratio by a historical growth rate in earnings. (There are forward-looking PEG ratios, too.)

Logitech’s five-year historical earnings growth rate is 48.1%, which makes its PEG ratio 0.4. Logitech’s PEG ratio compares to its industry median PEG ratio of 0.9; its percentile ranking against all stocks is 14.

Therefore, the PEG ratio gives further confirmation of Logitech as an attractively priced stock that warrants further analysis. The company is undervalued based on its historical earnings growth rate and current market expectations represented in the PEG ratio.

AAII Screens With PEG Ratio Filter

Go to www.aaii.com/stockideas/allstrategies and click on a screen’s name to read more about the criteria the screen follows.

Where to See Valuation Metrics

AAII members have access to a stock’s valuation metrics through the Stock Evaluator at AAII.com. Type the name or ticker of a stock into the search box at the top of the website and select the company link that appears in the drop-down menu. Valuation metrics are on the Snapshot tab.

AAII Screens Employing the Price-Earnings & PEG Ratios

We have a number of screening strategies incorporating the price-earnings ratio and the PEG ratio that all members can access online as part of their membership (see the accompanying boxes). These screens are located under the Screening tab of AAII.com; choose Explore All Screens from the drop-down menu for the complete list. Click on any screen name to open the overview for more information.

Discussion

BARRY J from TX posted over 2 years ago:

Matthew, I liked your clear, concise, efficient writing style. An interesting factoid I noticed in this article is the DIFFERENCE in VARIATION in selection criteria filters in the 9 “P/E Filters” and the 8 PEG “PEG Filter” lists. PEG filters have a much tighter spread and are generally consistent across filters. P/E filters vary more. This may be due more to the math in the calculations than their ability to discriminate. Thoughts?


KENT M from AZ posted over 2 years ago:

I have always enjoyed your articles directed toward new or novice investors, but from past experience I think it would benefit the newbies with visuals showing where figures like P/E, PEG, P/B and other abbreviated terms are located or derived. Showing a few examples speeds the understanding of terms not commonly used.


KENT M from AZ posted over 2 years ago:

I have always enjoyed your articles directed toward new or novice investors, but from past experience I think it would benefit the newbies with visuals showing where figures like P/E, PEG, P/B and other abbreviated terms are located or derived. Showing a few examples speeds the understanding of terms not commonly used.


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