What Does a Low P/E Ratio Mean?

The other day, I noticed that one stock that's long occupied my watch list -- steelmaker Nucor (NYSE: NUE  ) -- is sporting a price-to-earnings ratio of less than 10. That got me wondering what other attractive companies might be sporting low P/Es. So I ran a quick screen for similar companies at Yahoo! Finance, and among firms in the S&P 500, I found the following (and many more):

Company

Trailing P/E

Forward P/E

Nucor

9.86

9.86

Countrywide Financial (NYSE:CFC)

6.08

6.84

Genworth Financial (NYSE:GNW)

10.12

8.48

Allstate (NYSE:ALL)

6.68

8.22

Goldman Sachs (NYSE:GS)

8.30

8.09

E*Trade Financial (NASDAQ:ETFC)

10.11

8.29

Pfizer (NYSE:PFE)

10.06

10.58

Source: Yahoo! Finance. As of 8/22/07.

But before you rush out to buy any of these, please keep the following in mind:

  • Know what you're looking at. A P/E ratio represents a company's recent stock price, divided by its earnings per share (EPS). When you see P/E ratios listed for companies, they're often "trailing," meaning that the stock price is divided by the EPS for the four most recently completed quarters. So if a company has earned $1.25 per share over the past year, and it's trading for $40 per share, its trailing P/E would be 32 (40 divided by 1.25). Meanwhile, you can also often find "forward" P/Es, which use the expected EPS numbers for the coming four quarters. So if a company whose stock is trading at $40 per share is expected to earn $1.50 per share, its forward P/E would be 27.

  • Check the difference between trailing and forward P/E numbers. If the forward P/E is lower, that means future earnings are expected to be higher than the recently completed annual earnings. If the forward P/E is higher, it means the company is expected to earn less over the coming year than it did in the past year -- not a great sign, in general.

  • Remember that the P/E isn't everything. Other metrics are also worth considering. Many people would reasonably argue that the P/E isn't even all that valuable, since a company, via accounting tricks -- legal and otherwise -- can manipulate earnings to some degree. If you find a company with a low P/E, try to determine why it's low. See whether the company has encountered any problems recently, and determine whether those problems will likely be temporary or permanent. Many lenders, for example, are being pressured by issues surrounding subprime lending these days.

  • Understand that P/Es vary by industry. Steelmakers, for example, will usually sport seemingly low P/Es, as will automakers and others, especially those in capital-intensive fields. Software makers and other "lighter" businesses tend to have higher P/Es. So don't assume that a steel company with a P/E of 18 is more attractive than a software maker with a P/E of 25.

  • Compare a company's current P/E with its historical P/E. A glance at Nucor's historical P/Es, for example, suggests that this might be an attractive time to buy, with a relatively low price compared to earnings. (This is a good time to visit our CAPS stock-rating community, too, to see what others think of the opportunity.)

If you'd rather leave it to others to find promising stocks, take a free trial of our Motley Fool Champion Funds newsletter, which offers some terrific mutual fund recommendations every month in an easy-to-digest format. A free trial will give you full access to all past issues, so you can read about each recommendation in detail.

Longtime Fool contributor Selena Maranjian does not own shares of any companies mentioned in this article. Pfizer is a Motley Fool Inside Value recommendation. Try any of our investing services free for 30 days. The Motley Fool isFools writing for Fools.


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