What do Warren Buffett, Ben Graham, Seth Klarman, and Peter Lynch all have in common? Besides being wildly successful investors, they’re all are adherents to value investing, a method where one attempts to buy securities that have a higher intrinsic value than their current price.
One of the most basic forms of value investing is to find stocks with low price-to-earnings (PE) ratios. The PE ratio is a simple ratio that divides the current price per share of a company by the earnings per share over the trailing 12-month period. The logic behind buying low PE stocks is simple: As an investor, you are ultimately entitled to a pro-rata portion of company earnings, so paying the lowest cost, or multiple, for those earnings is preferable than paying a higher multiple. Essentially, your dollar is buying a larger portion of company earnings than it would with a high-multiple stock.
The risk of investing in low PE stocks
Success by investing in low PE stocks far from guaranteed. In fact, there are a few prevalent risks with using low PE ratios as your sole source of investment decision-making. First, multiple factors can determine earnings, and not all are directly related to the company’s operations. Non-operational company actions like gains from sales of equipment or subsidiaries, tax benefits, or winning a lawsuit are required to be reported as earnings, which skews the earnings upward. Likewise, losses from equipment sales, restructuring, or losing a lawsuit can temporarily depress earnings. Many financial outlets report normalized earnings to account for extraordinary items and discontinued operations, but it’s not guaranteed.
The second risk of investing in low PE stocks is related to operations. Investing is a forward-looking endeavor while the PE ratio is a backward-looking metric. When investors feel a company’s prospects have noticeably declined due to industry changes, economic conditions, or poor operations, they will proactively sell the company, depressing the price and leading to a low PE ratio. Often, this is referred to as a value trap if the company underperforms.
For this reason, many investors use estimated earnings over the next 12 months or forward earnings. However, it’s important investors understand these are earnings estimates and may not be attained by the company.
Conversely, low PE stocks that can turn things around often…