Although mathematically simple, taking a company’s price and dividing it by its earnings can tell an investor a great deal. The P/E ratio, as it is called, shows how much investors are willing to pay for a dollar of earnings. So, if a company has a stock price of $20 and earnings of $1.00, its P/E would be 20. Each dollar of earnings is worth $1 to the market. If that same company, trading at $20 per share, earned $0.50, however, the P/E would be 40—investors would be paying $2.00 for each dollar of earnings.
The price to earnings ratio is a valuation metric, helping to decipher if a stock is expensive or cheap. Although some use absolute metrics (a P/E over 20 is expensive, for example), P/E is most useful on a relative basis, comparing one company to its historical trends, to another company, or to an industry or market average. It is a way to measure that voting machine mentality of Wall Street about which Benjamin Graham wrote. The thought is that growth and momentum investors are willing to pay more for a dollar of today’s earnings to invest in a quickly growing company. A value investor, meanwhile, would prefer to wait until a company is “on sale” and trading at a low P/E multiple.
Every week Value Line publishes screens of the highest and lowest P/E ratios in the Index section of The Value Line Investment Survey. Although the common refrain is that value seekers should focus on the lowest P/E screen and growth and momentum investors should focus on companies with higher P/Es, this isn’t always true. The high P/E screen often turns up companies in the midst of a turnaround. So, while growth and momentum investors may find quickly growing companies on the high P/E list, value investors willing to sort through the 100 names that make the low P/E screen can also find some hidden gems.
A recent screen turned up rapidly growing companies like TIBCO Software (TIBX) and Masco Corporation (MAS).
TIBCO is a leading independent provider of middleware and infrastructure software. The company’s solutions enable businesses to integrate internal operations, business partners, and customer channels in real time. Using its products, customers are able to create what TIBCO calls “the two-second advantage,” or the ability to capture relevant information and quickly use it for a competitive advantage. This real time correlation of events with expected behavior allows a company to better anticipate customer needs, capitalize on new opportunities, and avoid potential problems.
The company focuses its product development and sales efforts to create products that interoperate, and can therefore be sold together as a suite, though it also offers custom solutions designed to meet specific challenges. TIBCO divides its product offerings into three major categories: service-oriented architecture and core architecture; business optimization; and process automation and collaboration. It also offers customers professional services, such as consulting, maintenance and support, and training.
To reach its customers, TIBCO uses a mix of market research, analyst updates, seminars, direct mail, print advertising, trade shows, and customer newsletters to achieve its marketing goals. The company distributes its products through a direct sales force, software vendors, and through systems integrators.
TIBCO is working on several initiatives, such as enhanced cross-selling, mainstreaming across non-core customers, and acquisition opportunities, that we think will help it deliver solid revenue growth this year. Indeed, we think the company has ample space to grow sales, given that only 10%-15% of current customers use the company’s full suite of offerings.
Masco manufactures, distributes, and installs home improvement and building products, with particular emphasis on brand-name consumer products and services that are well-regarded in their markets. The company offers a wide array of building products at a variety of price points, including faucets, architectural coatings, windows, and cabinets, and it is among the largest installers of insulation, as well. Products are distributed through multiple channels, including directly to homebuilders, wholesale, and retail channels. It divides its operations into five segments, Cabinets and Related Products (16% of 2011 sales); Plumbing Products (39%); Installation and Other Services (14%); Decorative Architectural Products (22%); and Other Specialty Products (9%).
Masco was hard-hit in the U.S. housing collapse, and had been held back by excess capacity. Consequently, the company underwent a restructuring that has been largely completed. It consolidated business, closed plants, and reduced headcount, much of it within the Cabinets and Installation segments. All told, some $80 million in Cabinet and Installation losses are expected to be eliminated this year.
Masco’s top line has declined each year since it peaked in 2006, but we project that the company has likely reached an inflection point, with the trend becoming positive this year. Earnings, which were likewise hampered by the wider economic difficulties, should improve over the next three to five years, and bring down the stratospheric P/E multiples we have seen here in recent years. We think this issue offers investors solid recovery potential over the pull to mid-decade.
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.