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