Value Investing And Buying Income On The Cheap

When purchasing stocks, you are essentially buying the right to receive a share of a company’s income. But the income of some companies sells in the stock market for much less than it does for others. The measure used to compare companies by how much investors must pay for each dollar of income is called the Price to Earnings (P/E) ratio. A company with good growth prospects such as Google (GOOG) trades for a relatively high P/E of 30, meaning the market value of Google’s stock is such that one has to pay $30 for every $1 of income that Google earns.

Studies have repeatedly found that over the long term, stocks with low P/E’s tend to outperform their high P/E counterparts. There are a few theories for why this might be so, one being that investors overpay for stocks deemed to have good growth potential. Another is that low P/E stocks offer investors plenty in the way of upside (since when market sentiment shifts, P/E’s for low P/E stocks may expand, while P/E’s for high P/E stocks can’t go much higher) while high P/E stocks offer plenty of downside for the same reason.

Even the same company can have P/E levels that vary over time, as market sentiment constantly shifts. For example, consider the historical P/E level of Coke (KO):

coke historical PE

Clearly, investors who purchased Coke stock in the early 80s were able to buy Coke’s earnings at a good price (the P/E was less than 10) and profited handsomely as the P/E expanded in subsequent years.

This pattern is a familiar one. Plenty of worthy companies go through periods where investors can purchase them at good prices relative to their earnings. We’ve seen similar charts with respect to the Home Depot, Microsoft, and Walgreens, all of whom appear to be currently trading at low P/E levels relative to their histories.

By identifying companies trading for less than what they are worth, an investor increases his chances of benefiting from long-term price appreciation.

About the Author

By , on Jun 18, 2009
Saj Karsan
Saj Karsan regularly writes for Barel Karsan, a site dedicated to finding and discussing companies that sell in the stock market for less than they are worth. If you enjoyed the article above, consider subscribing to the Barel Karsan RSS Feed.

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Leave Your Comment (3 Comments)

  1. Jonathan says:

    Excellent analysis. I do agree that investors often overpay in the first instance, usually because investors buy into a trend. For me I like to try and spot the rising stars. This means that you can frequently get it wrong, but it’s nice when they turn out to be good predictions and you earn a substantial return.

  2. Bernz says:

    I agree with Rajeev here in regards to realizing that PE ratio is not the only way to determine whether a particular stock is a good investment or not. I learned this the hard way, after buying and trading stocks for quite a long time. I only started making money in stocks when I started to not listen to everything that the so-called-experts say. Still a good fundamentaly sound company should be consider as with any stock investing.

  3. Rajeev Singh says:

    PE is a great tool to identify winning stocks,but, they are not the only factor to be taken in consideration. One must also look at the company fundamentals, the quality of management team, the business prospects in next 10-15 years etc before deciding on investing in a firm. A company with a low PE will give upside returns only if the other factors mentioned are in its favour .

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