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.
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 contains both the actual P/E and the company’s relative P/E. A relative P/E above 1.00 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 at a high price and pinpoint the ones that are trading relatively inexpensively. As a valuation tool the P/E is 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 Survey. For value-oriented investors, this list of low Price to Earnings ratio stocks is a great place to start looking for investment ideas. Below is information on two companies that were recently found on this list: Rio Tinto (RIO) and Allstate Corporation (ALL).
Rio Tinto is the second largest mining company in the world. Major products include iron ore, aluminum, copper, and diamonds. The company also produces energy assets, such as coal and uranium, as well as industrial minerals, which include borax, titanium dioxide, and salt. Although operations are spread across the globe, there is a significant concentration in North America and Australia.
The company stands to register decent profits in 2014, compared to last year’s tally. The economic recovery in the United States appears to be on track, supported by improving trends in the housing and employment sectors. Unfortunately, conditions have been a bit choppy in Europe, while things are less than ideal in China and a number of other emerging markets. Still, Rio Tinto’s recent progress on the sales front can be traced largely to a rise in production levels for key products, like iron ore, thermal coal, and copper. This has, in many cases, offset unfavorable commodity prices. At this point in time, we believe that full-year earnings will be $5.80 per ADR, about 5% higher than the 2013 level. Assuming that the business environment is generally favorable, the bottom line might well reach $6.50 per ADR in 2015.
Meanwhile, cost-reduction initiatives have been quite successful of late. Rio Tinto’s operating margin was about 38% in 2013, and ought to remain wide this year. Improved efficiency has resulted from savings in a few areas. For example, the company has lower operating expenses, and reduced its staff size by around 4,000 in numerous departments. Another 3,000 positions were eliminated, as several non-core businesses were divested. Elsewhere, Rio Tinto has cut back somewhat on exploration and evaluation spending over the past year. All told, results in 2014 should benefit from the aforementioned measures. At present, RIO's price-to-earnings ratio stands at 9.93, well below the Value Line average of 17.8 in 2013.
Allstate is the second-largest property/casualty insurer, and one of the biggest life insurers in the United States. The property/casualty insurance division is comprised of standard auto, nonstandard auto, homeowners, and other personal lines. The life insurance unit includes annuity, term, universal life, and whole life.
The company’s earnings might take a step back in 2014, versus last year’s figure. For the month of January, management reported that catastrophe losses came in at approximately $180 million, net of taxes. This is somewhat noteworthy because if this statistic is extrapolated over 12 months, the run-rate would exceed 2013’s catastrophe figure of $1.25 billion by a decent margin. True, one month alone does not indicate a trend, though we believe that last year’s historically low loss level will be very difficult to maintain over the long term. Hence, the primary factor behind our expectation for a profit drop in 2014 is an uptick in the combined ratio. All things considered, share net may slide about 10%, to $5.10.
But business prospects for next year look brighter. Indeed, there are signs that the domestic economic backdrop will continue to exhibit improvement. It’s also important to mention that Allstate’s fundamentals appear to be in fairly good shape, as the company’s large size, ability to underwrite policies at attractive prices (thanks to its customer-oriented approach), and the likelihood of increased returns on fixed-income securities over the next couple of years, seem promising. Consequently, the bottom line stands to advance around 13%, to $5.75 a share, in 2015.
At the time of this article's writing, the author did not have positions in any of the companies mentioned.