q
Value investors buy low PE stocks: For those who subscribe to the value investing
school, one measure of value is the price earnings (PE) ratio. Thus, when
comparing across stocks, a stock that trades at five times earnings is viewed
as cheaper than one that trades at ten times earnings.
q
A low PE stock is an attractive alternative to
investing in bonds: For those investors who
prefer to compare what they make on stocks to what they can make on bonds,
there is another reason for looking for stocks with low price earnings ratios. The
earnings yield (which is the inverse of the price earnings ratio, i.e., the
earnings per share divided by the current stock price) on these stocks is
usually high relative to the yield on bonds. To illustrate, a stock with a PE
ratio of 8 has an earnings yield of 12.5%, which may provide an attractive
alternative to treasury bonds yielding only 4%.
q Stocks that trade at low PE ratios relative to their peer group must be mispriced: Since price earnings ratios vary across sectors, with stocks in some sectors consistently trading at lower PE ratios than stocks in other sectors, you could compare the PE ratio of a stock to the average PE ratio of stocks in the sector in which the firm operates to make a judgment on its value. Thus, a technology stock that trades at 15 times earnings may be considered cheap because the average PE ratio for technology stocks is 22, whereas an electric utility that trades at 10 times earnings can be viewed as expensive because the average PE ratio for utilities is only 7.