There seems to be a common misconception out there that value investors only buy low PE stocks and ignore high growth stocks. Here is something that might surprise you :
The PE by itself tells us nothing about value.
Here is a sample:
Let’s say a Stock A has a PE of 8 and Stock B has a PE of 15. Is Stock A a better value stock?
What if Stock A is growing its sales and profits at only 2% a year and Stock B grows by 10%?
Even worse what if Stock A is in a commodity business with dismal margins and ROIC of 3% while Stock B has an amazing 30% ?
All of the sudden Stock A doesn’t look cheap at all. In fact people could argue that Stock B is a much better Value stock
Even worse:
What if Stock A has a lot of debt ? The PE won’t factor this in at all. What if the company has a market cap of 1 billion but another 2 billion in debt.
All of the sudden we are looking at and enterprise value of 3 Billion. Can this company even pay it’s interests? When you look at PE you might overlook all the other issues with the company. A low PE could be a good start for your research but by itself its meaningless.
Another sample :
What if Stock A has a PE of 3 and Stock B has a PE of 100. No real value investor would buy this PE 100 stock. Its obviously overvalued. But is it really?
What if they both had big one off events? Let’s say Stock A sold parts of its business and booked the proceeds as profits.
These proceeds won’t be there next year and the company will likely have a much higher PE once they return to normal. In fact since they sold parts of their Company it is even possible that they will earn less money in the future. All of the sudden that PE 3 stock doesn’t look so cheap anymore.
Same with Stock B. What if it made decent profits year after year and in one year they decided to make a big acquisition that messed up their normal PE.
A lot of people would say right off the back that a PE of 100 is expensive and overvalued. Is it? Next year the big expense won’t be there anymore and the company will likely earn more than before. All of the sudden the PE of 100 turned into a great opportunity
Value investing is a lot more than just running a scanner and looking for low Price Earnings Values. It can be a great start for your research but keep in mind that there are many more variables that should be considered.
As investors we need to create a whole picture out of many small puzzle pieces. PE is just a small piece