Value investors are fond of using the P/E metric, and most understand its limitations. When discovering a stock with what appears to be a low P/E, it may suggest that you have discovered a great buy. The important factor is that it “suggests;” it and does not necessarily validate it. By itself, the P/E tells you nothing. The P/E is best used by comparing similar companies or competitors or the same industries. For example:
Looking at the column P/E, you will note that Target (TGT, Financial) has the lowest P/E among these competitors. Their P/E is also lower than the industry standard for these types of companies, suggesting that it is potentially a good buy. Walmart’s (WMT, Financial) P/E is slightly higher, yet also lower than the industry P/E. Costco (COST, Financial), Sears (SHLD, Financial) and PriceSmart (PSMT, Financial) all have P/E’s that exceed the industry and their top competitors, suggesting that they may be overvalued.
While the lower P/E “suggests” value, companies with higher P/Es may be the better value if they possess less debt and are growing faster. While Walmart’s P/E is higher than Target's, their debt to equity and five-year growth appears to make it the overall best choice. The caveat to all this is that there is a lot more in picking stocks than these metrics. I am not suggesting that Walmart is better than Target or any other of the stocks in the group. This exercise is only to demonstrate how you need to compare P/Es: Not in a vacuum, but by comparisons with its peers.
As value investors we occasionally unearth a stock that has struggled in recent years and through our research, conclude that the demise is only temporary and better days lay ahead.
But what happens when we start our research and notice that the P/E is 0? The stock has a price, but no earnings. It obviously still has revenue and you may have noticed that several gurus hold the stock in their portfolio. You know that a low P/E is good, but somehow have at least understood that the company needs to earn money for you to make money and that a P/E of 0 cannot be good. The confusion becomes greater when we attempt to deconstruct the P/E by inverting it to E/P to get our earnings yield, a more important number in comparing the risk of the stock with a bond. Regardless of the price, you end up with the earnings yield being 0.
This is where the “other P/E” comes in. I recently wrote how we “mechanically” use metrics and other devices without fully understanding what they mean. For instance, when talking about P/E, the formula is:
Price per share
Earnings per share and (EPS is equal to a simplified: net income/outstanding shares)
Most items in balance sheets, income statements and cash flow statements are often related in one way or another. P/E and P/S, for instance are kissing cousins that are related by way of the net profit margin. We get lazy and don’t consider alternate ways of looking at the same thing. Consider the “other P/E”. While not perfect, it helps or is one of several ways to get past the 0 that we are seeking to look beyond.
P/E =
Profit Margin
While companies may have run into turbulent times and temporarily have diminished earnings, they do still have sales or revenue. If not, they may as well close their doors. So, they are still selling, and we expect things to get better. Look at their P/S ratio and divide it by “normalized” margins. We will look at the formula with a company that has both a P/E and P/S and see how this works. If for example, a company such as Walmart has profit margins like these:
Walmart’s P/E is currently 13.4 and the P/S is 0.50. We might conclude that the “normalized” margins are approximately 3.43. As with any other metric, we are trying to get close. That is, approximately correct rather than specifically wrong. We end up with a P/E that is close to the current P/E and is only skewed by the fact of using “normalized” earnings.
P/E = 0.50
3.43 = 14.57
If you have a stock with 0 earnings but with a P/S of .80 and normalized margins of 5.6, you can get this suggestive P/E: 0.80/5.6 or 14.28 and implies an earnings yield of 7%. This is only a suggestion for a stock that other metrics and further study get you to conclude that you are looking at a depressed stock about to recover. This gives you the important earnings yield that may help you along the path of discovery. Also compare the stock's P/S ratio, P/B ratio, etc., with peers. Use the tool wisely, but know exactly its shortcomings.
Disclosure: No holdings among wmt, tgt, cost, psmt, shld
| Company | Ticker | P/E | Debt to Equity | 5 Yr Eps Growth |
| Walmart | Wmt | 13.40 | 62 | 11.80 |
| Costco | Cost | 25.30 | 20 | 5.10 |
| Target | Tgt | 12.70 | 101 | 5.70 |
| Sears Holdings | Shld | 45.00 | 31 | -33.20 |
| PriceSmart | Psmt | 23.40 | 16 | 0.00 |
| Industry | 15.60 |
Looking at the column P/E, you will note that Target (TGT, Financial) has the lowest P/E among these competitors. Their P/E is also lower than the industry standard for these types of companies, suggesting that it is potentially a good buy. Walmart’s (WMT, Financial) P/E is slightly higher, yet also lower than the industry P/E. Costco (COST, Financial), Sears (SHLD, Financial) and PriceSmart (PSMT, Financial) all have P/E’s that exceed the industry and their top competitors, suggesting that they may be overvalued.
While the lower P/E “suggests” value, companies with higher P/Es may be the better value if they possess less debt and are growing faster. While Walmart’s P/E is higher than Target's, their debt to equity and five-year growth appears to make it the overall best choice. The caveat to all this is that there is a lot more in picking stocks than these metrics. I am not suggesting that Walmart is better than Target or any other of the stocks in the group. This exercise is only to demonstrate how you need to compare P/Es: Not in a vacuum, but by comparisons with its peers.
As value investors we occasionally unearth a stock that has struggled in recent years and through our research, conclude that the demise is only temporary and better days lay ahead.
But what happens when we start our research and notice that the P/E is 0? The stock has a price, but no earnings. It obviously still has revenue and you may have noticed that several gurus hold the stock in their portfolio. You know that a low P/E is good, but somehow have at least understood that the company needs to earn money for you to make money and that a P/E of 0 cannot be good. The confusion becomes greater when we attempt to deconstruct the P/E by inverting it to E/P to get our earnings yield, a more important number in comparing the risk of the stock with a bond. Regardless of the price, you end up with the earnings yield being 0.
This is where the “other P/E” comes in. I recently wrote how we “mechanically” use metrics and other devices without fully understanding what they mean. For instance, when talking about P/E, the formula is:
Price per share
Earnings per share and (EPS is equal to a simplified: net income/outstanding shares)
Most items in balance sheets, income statements and cash flow statements are often related in one way or another. P/E and P/S, for instance are kissing cousins that are related by way of the net profit margin. We get lazy and don’t consider alternate ways of looking at the same thing. Consider the “other P/E”. While not perfect, it helps or is one of several ways to get past the 0 that we are seeking to look beyond.
P/E =
Profit Margin
While companies may have run into turbulent times and temporarily have diminished earnings, they do still have sales or revenue. If not, they may as well close their doors. So, they are still selling, and we expect things to get better. Look at their P/S ratio and divide it by “normalized” margins. We will look at the formula with a company that has both a P/E and P/S and see how this works. If for example, a company such as Walmart has profit margins like these:
| 2005 | 2006 | 2007 | 2008 | 2009 | 2010 |
| 3.60 | 3.60 | 3.20 | 3.40 | 3.30 | 3.50 |
Walmart’s P/E is currently 13.4 and the P/S is 0.50. We might conclude that the “normalized” margins are approximately 3.43. As with any other metric, we are trying to get close. That is, approximately correct rather than specifically wrong. We end up with a P/E that is close to the current P/E and is only skewed by the fact of using “normalized” earnings.
P/E = 0.50
3.43 = 14.57
If you have a stock with 0 earnings but with a P/S of .80 and normalized margins of 5.6, you can get this suggestive P/E: 0.80/5.6 or 14.28 and implies an earnings yield of 7%. This is only a suggestion for a stock that other metrics and further study get you to conclude that you are looking at a depressed stock about to recover. This gives you the important earnings yield that may help you along the path of discovery. Also compare the stock's P/S ratio, P/B ratio, etc., with peers. Use the tool wisely, but know exactly its shortcomings.
Disclosure: No holdings among wmt, tgt, cost, psmt, shld
