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):
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.