The price-earnings (P/E) ratio, commonly known as the earnings multiple, stands as a critical measure in the evaluation of a company’s market value. This ratio is the result of dividing the current price of a company’s stock by its earnings per share over the preceding twelve months. The significance of the P/E ratio lies in its ability to bridge a company’s recent earnings achievements with the market’s future performance expectations, as reflected in the current stock price. This relationship suggests that investors are willing to pay higher multiples for present earnings if they anticipate increased future earnings, in line with their expectations.

To navigate the complexities of determining whether a company’s P/E ratio is justifiable, analysts employ several models. One such approach, the relative price-earnings ratio method, involves comparing the P/E ratio of an individual stock against the aggregate P/E ratio of the market or the specific industry to which the company belongs. The American Association of Individual Investors (AAII) has developed a P/E Relative screen that has consistently outperformed the S&P 500 index since its inception. Between January 1998 and March 2024, this strategy delivered a compound annual growth rate of 13.8%, markedly higher than the S&P 500’s annual return of 6.3% over the same period. On average, this screen has identified 36 qualifying stocks, experiencing an average portfolio turnover rate of 21.3%.

The Concept of price-earnings relative

The price-earnings relative value is computed by dividing a company’s P/E ratio by the market’s overall P/E ratio. This calculation allows investors to compare a company’s valuation in the context of its market or industry average. A company with better prospects or lower risk than the market average, or both, is expected to possess a higher P/E ratio. Such a comparison is particularly valuable for isolating investment opportunities within a specific sector, as it can reveal companies that stand out from their peers in terms of value.

Changes in the P/E relative value can indicate shifts in market expectations about a company’s future earnings potential or signal potential mispricing. It’s important to note, however, that the P/E relative valuation model assumes the long-term growth and risk profile of a company remains constant. A thorough assessment of a company’s P/E relative is crucial before making investment decisions to ascertain if it offers a reasonable valuation moving forward.

Interpreting the P/E relative

A P/E relative value exceeding 1.00 suggests that a company’s P/E ratio is higher on average than the market’s P/E ratio, indicating a potentially higher valuation by the market. Conversely, a P/E relative below 1.00 signals a company’s P/E ratio is generally lower than the market’s, possibly pointing to undervaluation. Deviations from the average P/E relative value can highlight discrepancies in valuation that may merit investor attention.

The process of calculating price-earnings relative

Calculating the price-earnings relative involves two primary components: the current market P/E ratio and the stock’s five-year average P/E relative. Tools like AAII’s Stock Investor Pro provide these metrics, facilitating the calculation of an adjusted P/E ratio that accounts for a company’s valuation in relation to the market. This adjusted P/E ratio, when used in valuation models, can help investors gauge whether a stock is fairly valued, overvalued, or undervalued by comparing the stock’s current price to its calculated valuation.

Screening for value: identifying undervalued stocks

The initial phase of screening for undervalued stocks involves selecting securities from major exchanges and excluding those with liquidity issues or negative earnings. The criteria also eliminate companies with extreme P/E ratios caused by short-term earnings fluctuations or other anomalies, ensuring that only firms with consistent and positive earnings are considered. This process aims to highlight stocks trading below their estimated fair market value, offering potential investment opportunities in undervalued companies.

In-depth analysis and stringent screening criteria are employed to sift through the vast universe of stocks, focusing on those with promising valuation metrics and positive earnings revisions. This approach helps identify companies that may have fallen out of favor with the market but possess solid fundamentals, offering a potential for revaluation and price appreciation.

Conclusion

The application of P/E ratios and relative P/E analysis in stock screening serves as a powerful tool for identifying undervalued companies with the prospect of returning to their historical valuation norms. While this strategy relies on the assumption that a company’s fundamental characteristics remain stable over time, it requires investors to perform thorough due diligence, examining a range of factors including earnings stability, growth prospects, and market conditions. Ultimately, investing in stocks based on P/E metrics demands a nuanced understanding of market dynamics and a cautious approach, acknowledging that success hinges on the accuracy of the underlying data and the validity of future performance expectations.