The Dangers of Low P/E Stocks
If you sometimes pick stocks based on a very attractive P/E ratio, then I
congratulate you for using that sensible approach.
But I warn you that it is very dangerous to apply this technique without
digging deeper. Sometimes low P/E stocks are no bargain at all.
For example in 1998, Air Canada had a trailing P/E of around 6 for much of
the first half of the year. It was trading around $12.00 and had 1998 earnings
of $1.98 per share. It looked like a great bargain. I bought it for its low P/E.
Only much later did I realize that over half of the earnings in 1997 were from a
one-time gain on asset sales. The P/E based on adjusted earnings was more like
12. Also the company had a very poor history of profits and a P/E of 12 was no
bargain.
After making a few mistakes like that, I decided to start digging a lot
deeper before concluding that a low P/E stock was a bargain.
The P/E ratio that you will see on YAHOO or in the newspaper is, in the
majority of cases, distorted by various one-time and unusual items that have
affected income over the past year.
Refer to my article Reported Net Income - can you
trust it? for a complete explanation of all the items that can distort
earnings and therefore the P/E.
For a review of what the P/E ratio means see my article Understanding
the P/E ratio.
To understand what level constitutes a bargain P/E consider a close study of
my article Does that P/E of 20 indicate a buy or is it a
sell?. This includes calculations that show you exactly how a higher
expected growth rate leads to a higher justifiable P/E ratio.
In summary, I encourage you to continue to use the P/E ratio in evaluating
stocks, but before you Buy do some extra digging to see if the earnings need to
be adjusted for one-time items.
Shawn Allen, June 9, 2001
www.investorsfriend.com