One way in which stocks are valued is the price to earnings ratio, commonly abbreviated as P/E or p/e. It is a fairly simple calculation that divides a stock’s price by the company’s earnings per share for a given 12-month period. The logic of the ratio is that by owning a share of a company you are, arguably, buying the future steam of earnings the company generates. The idea of the P/E is to show how much an investor is paying to own that particular stream of earnings.
If a company’s earnings are growing strongly, investors might logically assume that today’s earnings are worth more because of the potential for future growth. Conversely, if a company’s earnings are growing slowly or unevenly, it wouldn’t make logical sense to pay a premium. This last statement highlights an important aspect of the P/E ratio—by itself it provides minimal information. To properly use the P/E as a valuation tool, it must be compared to something.
In many cases, an individual P/E is compared to the average P/E of the broader market. Value Line publishes the P/E of the market each week for this very purpose. Moreover, each Value Line research report (you can see a sample here) contains both the actual P/E and the company’s relative P/E. A relative P/E above one suggests a valuation level above that of the broader market and a relative P/E below one suggests a valuation level below that of the market. Another common comparison is to consider the current P/E versus a company’s historical P/E ratio. This information is provided in the historical section of the Statistical Array on each Value Line report. Price to earnings ratios can also be compared between peers, to spotlight the companies in an industry that are trading dearly and pinpoint the ones that are trading relatively inexpensively. As a valuation tool the P/E is, well, very valuable and should be a part of every investors’ toolkit.
Very often, a P/E is best used to simply cut companies from a list of research candidates. It is, indeed, a quick way to pull out companies that are trading relatively cheaply from a much wider group. To this end, each week The Value Line Investment Survey contains a listing of the 100 companies with the lowest Price to Earnings ratios out of the approximately 1,700 followed by the Service (it is paired with a similar screen for the highest P/Es). For value-oriented investors, this list of low Price to Earnings ratio stocks is a great place to start looking for investment ideas. Below are a few companies that were recently found on this list.
Archer Daniels Midland Co.
Archer Daniels Midland's (ADM) business deals primarily with procuring, transporting, storing, processing, and merchandising agricultural commodities and products both in the United States and internationally. The company is divided into three divisions: Oilseeds Processing, Corn Processing, and Agricultural Services. Oilseeds Processing (43% of 2010 revenues) deals with origination, merchandising, crushing, and further processing of oilseeds (soy beans, sunflower seeds, canola, and palm) into vegetable oils and protein meals. The end products these substances help create include salad oils, margarine, shortening, chemicals, paints, commercial livestock and poultry feeds, and natural health, nutrition and specialty food products. Corn Processing (13%) involves corn wet milling and dry milling activities to produce syrup, starch, glucose, dextrose, and sweeteners. Ethyl alcohol is produced by the unit for industrial use as ethanol in gasoline. Agricultural Services (36%), buys, stores, cleans, and transports agricultural commodities, and resells them as food and feed ingredients and as raw materials for the agricultural processing industry. Foreign sales comprised 46% of the total top-line tally.
A number of factors are contributing to ADMs relatively low valuation. Oversupply of ethanol poses some risk for pricing and margins. In addition, demand for soybean meal has been relatively low recently.
On the bright side, the corn division is experiencing nice growth trends, partly because of the thriving beverage business. Many beverage makers use high fructose corn syrup in their products, thereby increasing demand for ADM’s corn sweeteners. The USDA expects a record corn crop this year, which should lower prices and help margins at the corn processing business and lead to more bushels for the agricultural services division to transport. Further, despite the weak soybean meal demand, other products of the Oilseeds division should do well this year, considering that the USDA projects that global demand for oilseed by-products will rise 4% to 6%.
Community Health Systems
Community Health Systems (CYH) owns, leases, and operates general acute care hospitals in non-urban communities in the United States. It also owns or partners with practitioner offices and ambulatory surgery centers. The company offers a wide range of inpatient and outpatient services. As of December 31, 2010, it operated 130 hospitals in 29 states.
The healthcare provider is defending itself against a lawsuit brought by Tenet Healthcare Corp. (THC, a prior hostile takeover candidate), which alleges that CYH overbilled Medicare by under-utilizing "observation" status and over-utilizing more lucrative "inpatient admission" status in order to inflate profits, and, thus, the attractiveness of a merger. The action has resulted in an SEC subpoena, and is contributing to the stock's low valuation (as are high unemployment levels). Based on the outcome of other lawsuits in the healthcare field, we think that the market's reaction may be overly severe.
Negatives aside, CYH may still realize healthy top- and bottom-line advances over the near term thanks partly to its best-in-class management team. Acquisitions leading to an increase in beds have set the stage for a solid margin performance in the short term and have not been affected by the litigation. Moreover, the 3- to 5-year picture appears bright, too, especially since all Americans are projected to be medically insured by that time frame.
Steel Dynamics (STLD) is involved in the manufacturing and distribution of steel products throughout the United States. It operates through three segments, Steel Operations, that offers hot rolled, cold rolled, and coated steel products, such as galvanized and painted products; Steel Fabrication, which fabricates trusses, girders, and steel decking for the non-residential building components market; and the Metals Recycling and Ferrous Resources Operations segment that offers heavy melting steel, busheling, bundled scrap, and other scrap metal products.
The company’s relatively low price to earnings multiple is being caused by speculation over weaker steel prices ahead. Management gave some encouraging comments regarding a reversal of this trend, but the market still appears skeptical. We believe that the negative sentiment may be overblown.
Against a better economic backdrop, the company’s growth strategies appear achievable. Upgrades to shredders and feeders have been doing a good job of bolstering volumes, and should continue to do so, especially when industrial activities pick up. These moves also enhance the company’s distribution and supply chain efficiencies, likely leading to cost savings down the road. The fact that STLD’s earnings are projected to grow at a steady pace while the issue is still trading at a relatively low P/E, indicates that these shares may be undervalued on a long-term basis.
At the time of this article's writing, the author did not have positions in any of the companies mentioned.