Typically, low price-to-earnings ratios -- P/Es, for short -- can signal bargain stocks. But not all P/Es are created equal, and automatically dismissing any stock with a high P/E could cost you a chance at plenty of successful investments.
The P/E ratio divides a company's stock price by its annual earnings -- usually those of the past year, but sometimes those expected in the current or coming year. Stock prices fluctuate, of course, and so do earnings. When earnings fall, a P/E ratio will expand. But low or falling earnings don't always signify a troubled company.
Economic cycles
Many companies occupy cyclical industries; their fortunes will rise and fall in step with the overall economy. When we're mired in a recession, the vast majority of companies will find their earnings pressured, as companies and consumers both cut back their spending.
In such an environment, if earnings fall while a company's stock price stays stable -- or simply falls less -- the P/E will rise. If you're screening for low-P/E stocks, these companies can end up excluded from your results.
Big and small
To lessen the chance that you'll miss out on great stocks solely because of their steep P/Es, consider looking instead at forward P/Es based on the coming year's earnings. If the past or current year has been tough, but Wall Street expects brighter days soon, the forward P/E will be much more attractive.
Check out some of the companies that popped up when I ran a screen for enterprises with high current P/Es (based on trailing 12-month earnings) and reasonable forward P/Es.
|
Company
|
Trailing P/E
|
Forward P/E
|
|
Carpenter Technology (NYSE: CRS )
|
713
|
11
|
|
People's United Financial (Nasdaq: PBCT )
|
55
|
22
|
|
Hartford Financial (NYSE: HIG )
|
68
|
5
|
|
Dr. Reddy's Laboratories (NYSE: RDY )
|
213
|
18
|
|
Golar LNG (Nasdaq: GLNG )
|
28
|
9
|
|
Nucor (NYSE: NUE )
|
78
|
11
|
|
ReneSola (NYSE: SOL )
|
75
|
6
|
Data: Yahoo! Finance, Morningstar
Each of the companies above is attractive in some way, despite its high trailing P/E. Golar LNG transports liquefied natural gas, which many expect will be in higher demand in coming years. ReneSola makes the solar wafers found in solar energy cells. If you think that solar energy will continue to gain popularity, perhaps partly due to government stimulus spending on alternative energies, then the company is worth a look. And as our global population increases and ages, especially in developing nations, India-based Dr. Reddy's generic drug business looks promising.
The overall global economic recovery will improve many companies' prospects, too. As construction and manufacturing pick up, steel giant Nucor and specialty metal specialist Carpenter Technology should benefit. A busier economy will also fuel financial companies such as People's United Financial and Hartford Financial, though rising interest rates could pressure profits.
More context
Remember that current P/Es are based on past results, while forward P/Es look to the future. In investing, the future counts most. However a stock has performed for you in the past, the choices you make about it today should be largely based on how you expect it to perform in the future.
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