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 stream 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.
Arrow Electronics (ARW) is a global distributor of electronic components and enterprise computer products to industrial and commercial customers. Within the components segment semiconductors accounted for 69% of last year’s sales, with the rest stemming from passive interconnect products. The computing unit derives sales from servers, software, and storage devices. The company also offers a wide range of value-added services like materials planning, design, programming, assembly, and inventory management. This year’s estimated sales are about $22 billion.
Following sharp recession-related declines in 2009, sales and earnings have more than recovered the lost ground. Indeed, both will most likely be at record levels this year, and modest annual increases appear to be in the cards through mid-decade. Still-easy comparisons helped drive year-to-year top- and bottom-line gains in the first half of 22% and 61%, respectively. Moreover, a prospective acquisition of a value-added distributor should meaningfully expand the company’s operations in China.
Arrow’s share price has dropped some 37% from a mid-May peak due to concerns over how the current macroeconomic backdrop will affect electronics and enterprise computing demand. Currently, the shares are trading modestly below 2010’s closing price, despite this year’ estimated earnings gain of roughly 25%. Based on the current relatively low P/E ratio, this stock has attractive recovery potential both for the near term and over the pull to 2014-2016.
Ford Motor Company
Ford Motor Company (F) is the second-largest domestic manufacturer of trucks (64% of product sales in the United States) and, in 2010, it had the fourth largest market share of automobiles. Following the disposition of a number of brands in recent years, its two remaining brands are Ford and Lincoln. The company also sells vehicles in South America, Europe, Asia, and Africa. In addition, Ford has sizable leasing and rental operations and it manufactures electronic equipment.
The company has reduced its labor costs considerably as a result of new agreements with the United Auto Workers Union. Consequently, although sales in 2010 were 8% below 2008’s level, adjusted share earnings were $1.91 last year versus a loss of over $3.00 in 2008. Helped by the introduction of fuel-efficient vehicles powered by Ford’s EcoBoost engines, earnings will likely improve modestly this year and next. Further, the company is in the midst of aggressively expanding the Ford brand in India, as evidenced by the recent commencement of construction on a $1 billion manufacturing and engineering complex in that country.
Ford shares are selling at the low end of the 12-month trading range, and about 55% below the high end. Similar to Arrow, would-be Ford investors appear concerned over weak global economic data. Based on our estimated cash flow per share for 2011 and the Value Line multiple, this stock appears to be attractively valued for purchases.
Specialty-chemicals manufacturer, Solutia (SOA) has leading market shares in the three product segments that comprise its business. The Advanced Interlayer division produces polyvinyl butral (PVB), which improves the safety, energy efficiency, and quality of glass. Performance films output is used for automotive and architectural glass-related applications and other advanced technology purposes. Finally, the Technical Specialties unit has the leading market share in four segments, including heat transfer and aviation hydraulic fluids.
Earnings are on track to advance substantially in 2011, and we look for double-digit gains in each of the subsequent four years. Given strong free cash flow (estimated at $270 million this year), the capital structure has been improving considerably. Despite the expected earnings gain, this stock has dropped over 25% in price thus far this year, and its valuation, based on the current P/E ratio is appealing, in our view.
At the time of this article's writing, the author did not have positions in any of the companies mentioned.