One of the easiest and simplest metrics that investors use to screen for, as well as value, stocks is the price-to-earnings ratio, better known as a stock’s price-to-earnings (P/E). Of course, on its face, a P/E is nothing more than a snapshot in time, but what if I told you it was far more complicated than that?
There are several P/Es that you need to keep in mind. Sure, there is the current P/E, which reflects a stock’s price divided by the current year’s expected earnings per share, but there are also trailing P/Es, as well as price-to-peak-earnings and price-to-trough earnings. Obtaining a stock’s price is fairly simple; after all, there is no shortage of online services — both free and paid — that share what I call the basic information about a stock. That data set includes the company’s name, ticker, share price, traded volume, average traded volume and so on. When I say basic, that’s the information that barely gets you started, and it can be found at Yahoo! Finance or even Google Finance. There is far more data to be found by culling through those and other resources, but I’m talking with you today about P/Es.
Using a simple P/E screen is one way to hunt for cheap stocks or identify overvalued ones, but what if I told you that if you weren’t careful, you could be making a big mistake when using the easy-to-calculate P/E ratio? Making this mistake could mean the difference between finding a truly inexpensive stock and misidentifying one that really isn’t.
Even before you get going on which of the several P/Es to use, you have to have a firm grasp on the earnings-per-share figure you are going to use and whether or not it represents the true growth rate of the company’s business.
You are probably saying to yourself, “What… did… he… just… say?”
Let me come at it from a different perspective.
During the last several quarters, many companies have taken advantage of the Fed’s intentional low-interest-rate environment to float corporate debt and buy back their shares. As they have shrunk their share count, and racked up debt in the process, it gives the illusion that their earnings per share are growing faster than the growth of the actual business.
What you have to remember is that when a company reports the “earnings” that it and Wall Street are talking about, it’s earnings per share, or EPS. Now that we’ve cleared that up, there are a few ways companies can improve their EPS comparisons on a year-on-year and quarter-over-quarter basis. After all, earnings per share equates to earnings, or net income, divided by the outstanding share count (with certain adjustments).
Chris Versace is the editor of PowerTrend Brief — a FREE, weekly electronic newsletter. He also writes PowerTrend Profits, a paid monthly newsletter that helps individual investors profit through buying shares of companies poised to win big in the 8 PowerTrends, as well as writes the PowerTrader trading service that seeks to deliver short-term gains using stocks, ETFs and options. Chris has been ranked an All Star Analyst by Zacks Investment Research.