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 20.0. Each dollar of earnings is worth $20 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 $40.00 for each dollar of earnings.
The price to earnings ratio is a valuation metric, helping to decipher if a stock is expensive or not. 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 norms, 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 Rackspace Hosting (RAX) and Cabot Oil & Gas 'A' (COG).
Rackspace Hosting, Inc, (formerly known as Rackspace.com, Inc) was founded in 1998 and is based in San Antonio, Texas. The company offers cloud computing services, and manages web-based IT systems for its customers worldwide. Products include customer management portals, as well as cloud servers for computing, storage, and applications (including email, collaboration, file back-ups, and hybrid hosting). Most of its services are sold via direct sales teams, third-party channel partners, and online ordering.
The company’s stock price has suffered since our last issue, dropping almost 20% as a result of concerns regarding its changing product offerings (Rackspace is currently moving towards a more risky cloud computing strategy, which is worrying for many shareholders.) Another source of unease is the recent operating system shift for its Cloud service, which will now be powered by Openstack, an operating system designed with several other parties, including NASA. Such a major move is sure to induce short-term volatility in earnings (given the massive costs involved in this investment), though it should provide various benefits over the long run. Rackspace is also planning on expanding its market share, leveraging its strong leadership position in the industry to create new cloud computing platforms, as well as benefiting from the transparency provided by the OpenStack system, which should give it some advantages with clients.
Despite management’s commitment to the company’s long-term plans, readers should note that the current stock price (in spite of the recent drop) seems to have discounted much of the gains we projected. Therefore, only aggressive growth investors should consider the shares at these price levels.
Cabot Oil & Gas 'A'
Cabot Oil & Gas, founded in 1989, and located in Houston, Texas, is an oil and gas company engaged in the development, exploration, and production various liquids and gases. These include natural gas, crude oil, and natural gas liquids in the United States. Plays are mainly located in the Appalachia, Texas, and Oklahoma. In addition to the above, Cabot also transports, stores, gathers, and produces natural gas for resale. Customers include local distribution companies, gas marketers, intrastate pipelines, natural gas processors, and marketing companies.
Cabot has done surprisingly well given its tough operating environment (low natural gas prices being the biggest challenge, at present). Indeed, the stock’s performance compared to its peers has been quite strong, despite its untimely rank (Timeliness Rank: 4). That said, it has not escaped the industry-wide barrage unscathed, and its current stock price of $40 is moderately below the 52 week high of $45. Furthermore, the company’s record production is likely to work against profits in the short term, given the depressed natural gas prices, a result of the supply glut. However, unlike many of its peers, the company remains in good shape financially, with considerable balance sheet strength, and flexibility to get through possible future problems without major difficulty. At the same time, it is quite likely that Cabot will be busy on the acquisition and merger front, taking advantage of the weakened state of many of its peers.
At the recent junction, this issue is a mixed bag. It has a low beta, making it an interest to risk-averse investors, and its enterprise value exceeds its current market cap, making it of value to savvy investors. That said, its high P/E might make this stock too expensive for some investors.
At the time of this article’s writing, the analyst did not own any stock in the companies mentioned.