What does PE ratio signifies?
1. One of the common explanations of the PE ratio is that it tells you how much investors are willing to pay for every dollar in earnings that a company is generating.
2. However, PE ratio is also a measure of what kind of growth, investors are expecting from a company in the future.
- For example, take two stocks, one with a PE of 50 and the other with a PE of 10. Earnings drive stock prices, so if investors are willing to pay 5 x as much for one company's dollar of current earnings as they are for the other company's dollar in current earnings, they must be expecting that the first company will grow earnings much more rapidly than the second.
This idea of expectation was key.
- High-flying growth stocks with high PEs had so much expectation built into them that they often fell at the slightest sign of disappointment.
- Low PE stocks, however, have little anticipation or expectation built into their price. Therefore, any improvement in performance is likely to boost the attention they get, while they suffer little if their results don't meet the Market's already low expectation.
Low PE Investing
John Neff wrote, "Indifferent financial performance by low PE companies seldom exacts a penalty. Hints of improved prospects trigger fresh interest. If you buy stocks when they are out of favour and unloved, and sell them into strength when other investors recognize their merits, you'll often go home with handsome gains."
Neff continuously searched the newspapers for companies with low PE ratios (i.e. the least popular stocks in the market), also keeping tabs on those that had just posted new lows or were getting hammered in the press. From these shunned firms, he used a series of quantitative measures to identify those that were good bets to rebound.
He explained, "Swept up by flavours of the moment, prevailing wisdom frequently undervalues good companies. Many - but not all - that languish out of favour deserve better treatment. Despite their solid earnings, they are rejected and ignored by investors caught in the clutch of groupthink."
The challenge of course, is separating the stocks that are unfairly being beaten down because of overreaction from those that deserve their low prices.