How to Find Undervalued Stocks by using Price-to-Earning (P/E) Ratio?
Here is a question.
I have two stocks: Stock A and Stock B.
Stock A is trading at $ 1.00 a share. Stock B is trading at $ 10.00 a share. Which of the two stocks is cheaper?
What would your answer be?
If your answer is ‘Stock A’, please read on. I’ll share how most investors, sincere as they are, fail to achieve consistent returns from investing in the stock market today.
Perhaps, you may ask: ‘Can Stock B be possibly cheaper than Stock A?’
The answer is ‘Yes’.
If you are a savvy investor, you may request for more information regarding the two stocks before answering the question above. It is not possible to determine which of the two stocks is cheaper by knowing their current share prices alone.
This, I believe, is one of the biggest mistakes that most people make when they are investing in the stock market. As a matter of fact, they are not investing but rather speculating, betting, or even gambling their money through stocks in the stock market.
So, how is it possible for Stock B to be cheaper than Stock A?
For savvy investors, they would calculate the valuation ratios of a stock in order to identify the cheaper of the two stocks. One of these ratios is P/E Ratio and it is one of the most widely used ratios by value investors today. It is part of the top 5 ratios we used here at Value Invest Asia.
What’s P/E Ratio?
Price-to-Earnings Ratio (P/E Ratio) is a comparison of a stock price relative to its earnings per share (EPS). The formula is given below:
= Stock Price / Earnings per Share (EPS)
Let us go back to the question above. Supposedly, last year, Stock A has made a total of $ 0.02 in EPS while Stock B has made $ 1.00 in EPS. Now, which of these stocks would you choose to invest into?
|Stock Price||$ 1.00||$ 10.00|
|Last Year’s EPS||$ 0.02||$ 1.00|
|Current P/E Ratio||50||10|
What does it mean?
If you choose Stock A, it means, you are willing to invest $ 50 to own its shares to earn $ 1 a year. Meanwhile, if you choose Stock B, you are willing to invest $ 10 to own its shares to earn $ 1 a year.
As such, a savvy investor would view Stock B to be cheaper than Stock A based on their current P/E Ratio.
In general, savvy investors would aim to buy good quality stocks (profit growth, healthy balance sheet, nice cash flows, … etc) at their lowest possible P/E Ratio for they are undervalued. They would avoid buying stocks, good or bad, if their stock prices are overvalued. Here is a distinction between a savvy investor and the others:
Savvy Investors Use P/E Ratio to Find Value.
The Rest Buy / Sell Stocks based on Stock Price.
Why Do I Use P/E Ratio?
This is because it first reduces my investment risk. The companies must be profitable for me to calculate their P/E Ratios. It is not possible to calculate a stock’s P/E Ratio if it is not profitable (no or negative earnings).
Second, I personally find that the application of P/E Ratio is more meaningful, if the stock grows profits consistently over the long-term. There is no point for us to calculate P/E Ratio of stocks if their profits are reducing or inconsistent.
As such, I would avoid making investments into a stock which has reported:
- Negligible Profits.
- Inconsistent / Cyclical Profits (Eg. Turnaround Stocks).
- Declining Profits.
and would focus my investments into stocks which grow profits consistently.
Next, how do I personally use P/E Ratio to assess stock deals?
In brief, it involves three simple steps.
Let us use Jardine Matheson Holdings Ltd (JMH) as a case study. Firstly, I would compile JMH’s EPS figures for the past 10 years to make sure that the stock has a solid track record of growing profits consistently.
You may ask: ‘Why ten years? What about three years or five years?’
I believe, in a period of 10 years, there will be:
- Economic Booms and Busts.
- Strengthening & Weakening of Local Reporting Currencies.
- Commodity Booms and Busts.
- Political Uncertainties.
- Uncertainties caused by Technological Updates and Advancements.
I want to make sure that the stock is able to grow profits consistently in both of these times, good or bad. Personally, I view a stock to be resilient if it delivers a string of profit increments in a period of ten years. Not many stocks can deliver such results and I would view them as of investment-grade.
In JMH’s case, it has passed the test.
Source: JMH’s Annual Reports
Second, I would calculate JMH’s P/E Ratio for each year over the past 10 years. Here, I use the final price of the closing date of JMH for each financial year. For instance, JMH’s financial year ends on 31 December for each year. Thus, I’ll be collecting the closing stock price (at 31 December 2009) to calculate P/E Ratio 2009 of JMH and would do the same for 2010, 2011, … 2018.
These stock price data can be sourced from Google Finance or Yahoo Finance or from a stock’s annual reports.
If I couldn’t locate the closing stock price on the exact date (31 December), I’ll use the stock price closest to 31 December.
Out of which, I would have the following:
- 10-Year Lowest P/E Ratio: 10.55 (2009)
- 10-Year Highest P/E Ratio: 15.90 (2012)
- 10-Year Average P/E Ratio: 13.54
In other words, if I am interested to invest in JMH, I would aim to buy shares if they are trading at P/E Ratio close to 10.55 (the lowest) and avoid buying them if their shares are trading at P/E Ratio close to 15.90 (the highest).
Thirdly, I would calculate JMH’s current P/E Ratio. As of 14 June 2019, the stock is trading at US$ 64.96 a share. Based on its latest EPS of US$ 4.53 (2018), it has a current P/E Ratio of 14.34.
JMH’s Current P/E Ratio
= Current Stock Price / Latest EPS
= US$ 64.94 / US$ 4.53
It is above its 10-Year P/E Ratio Average of 13.54 and is closer to its highest P/E Ratio.
So, would you invest in JMH at US$ 64.96 a share today? You make the call.
Here, I’ll leave you with some takeaways:
- Investors Find Value. The rest buy or sell based on prices.
- P/E Ratio helps us avoid investing in mediocre stocks.
- Check 10-Year earnings track record before calculating P/E Ratio.
- A stock is Undervalued if current P/E Ratio is below its average.
- A stock is Fairly Valued if current P/E Ratio is close to its average.
- A stock is Overvalued if current P/E Ratio is above its average.
Another interesting valuation ratio to use is the price-to-book ratio, find out more about this ratio here.
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