The Secret Key To A Stocks Value Is Found In It’s Profit Over Earnings Ratio

In the long run, a company’s stock price rises or falls based on how fast its earnings grow. By comparing a stock’s price to the company’s earnings, you can see how fast investors expect those profits to grow. Herein lies the secret key to a stocks value.

A price-to-earnings ratio or P/E is a company stock price per share divided by the annual earnings per share of the company. P/Es represent how much investors will pay for each dollar of the company’s earnings per share. For example, if a stock has a P/E of 10, investors pay $10 for each $1 of profits. 

Generally, the more sure investors are of a company’s continuing growth and the more they expect it to be, the more they’ll pay for each dollar of the current earnings per share. In other words, the greater the investor’s optimism about a company, the higher its stock P/E will be.

Problems inevitably arise when investors are overly optimistic. For example, IBM’s P/E of 70 (circa late 1961) indicated that investors expected the company to grow several times faster than the typical company for an indefinite period. Even with IBM’s fabulous potential back in early 1961, the company couldn’t possibly have done that. If it had, we’d live in the United States of IBM today. Investors’ optimism was simply out of touch with reality. And the best warning of this was IBM’s unrealistically high P/E. In other words, IBM stock in late 1961 was the equivalent of a Porsche selling for a million bucks. It was a great company to demonstrate (for the sake of our example), but investing in the stock wasn’t a good deal. At the slightest hint of disappointment, IBM stock dropped dramatically.

Fathers of Value Investing

The secret key to a stocks value, otherwise referred to as the P/Es ratio can also tell us when stocks are cheap. In their legendary book ‘Principles and Techniques of Security Analysis,’ Benjamin Graham and David Dodd proposed that one crucial key to successful long-term investing is buying stocks with low P/Es.

The reason is that a stock with a low P/E sells at a low price relative to its earnings. At some point, they postulated, investors will realize that the company’s prospects are worth more, and they’ll bid the stock price up.

The other side is that stocks selling at relatively high P/Es have been bid too high relative to their earnings. At some point, investors will realize they have paid too much for those shares and either sell or stop buying. Either way, the high P/E stocks would underperform the low P/E stocks.

How can you tell if a high P/E issue causes a low P/E stock?

The best way is by looking at its relative P/E, which is how its P/E compares with the average stock. In 1962 (back to our previous example), IBM sold at seventy times its earnings. But just as important, its P/E was three times that of the average S&P 400 stock. 

The Graham-Dodd guidelines can also be applied to the stock market as a whole. In other words, just as an individual stock can sell above or below its realistic growth potential, so can stocks in general. The average we use is the P/E of the S&P 400.

Generally, the lower the P/E of the S&P 400, the greater the chance that stocks will rise. The higher its P/E, the greater the chance that stocks will drop.

Many of the most enormous fortunes on Wall Street were built by those intelligent enough to buy stocks when no one else wanted them. Low P/Es were one of the best tipoffs that the market was a bargain. At such times, stocks are the least vulnerable to bad news.

These savvy folks sold when equities became the rage when P/Es were relatively high. At such times, stocks are the most susceptible to bad news. Warren Buffett, J.P. Morgan, John Paul Getty, and John Templeton are but a few of these great contrarians.

Best Value Indicator

Undoubtedly, the secret key to a stocks value P/Es are the best indicators. For proof, compare them with the other two most widely used value indicators: the price-to-book-value ratio and dividend yield.

Like P/Es, the idea behind these value measures is that the lower they are, the cheaper stocks are. However, unlike P/Es, there are numerous problems with using them.

A price-to-book-value ratio compares a company’s stock price to its total assets per share. Specifically, it’s the stock price divided by the company’s equity (total assets less total debt) per share.

However, asset values can be altered by a thousand accounting tricks. Consequently, book values can be severely over or understated, and stocks with low price-to-book-value ratios can be expensive. Similarly, stocks with high price-to-book-value ratios can be cheap.

Dividend yields are what the company pays out to shareholders in annual dividends as a percentage of the stock price. For example, if a stock costs $10 per share and pays a $1 per share annual dividend, its dividend yield is 10%.

Companies can maintain dividends at unsustainably high rates for long periods before they’re forced to cut them. And stocks often hit bottom right after dividends are cut. As a result, dividend yields can also give a misleading signal as to whether stocks are unusually cheap or dear.

Another problem with dividend yields and price-to-book-value ratios is that they’re static measures. They reflect the past and ignore earnings, the key driving force behind stocks. 

The critical question for investors is whether stocks are expensive or cheap relative to their prospects for sustainable earning growth. And in this regard, only P/Es tell the story. Only P/Es compare a company’s earnings to its stock price.