Study after study has shown that stocks with low price-to-earnings multiples significantly outperform high-P/E stocks. Research from my favorite investing guru, New York University Prof. Aswath Damodaran, pegged the outperformance at anywhere from 9% to 12% per year, depending on the study period. That's big money we're talking about.
But you already know that you can't just go out and buy the stocks with the lowest multiples. Companies can trade at dirt cheap prices for a number of dire reasons, including low growth prospects, skepticism about earnings, or high risk of bankruptcy.
These dangerous stocks can quickly crater. Buy too many of them, and you'll increase your own risk of bankruptcy!
Thus, for a company to be truly undervalued, Damodaran says in his book Investment Fables, "You need to get a mismatch: a low price-to-earnings ratio without the stigma of high risk or poor growth."
Of course, you're unlikely to find any high-growth, low-P/E companies out there. But Damodaran suggests setting a reasonable minimum threshold for earnings growth, such as 5%. There are also various ways to minimize risk, including staying away from volatile stocks or companies with dangerous balance sheets.
The screen's the thing
We're looking for companies with low price-to-earnings multiples but also a relatively low amount of risk and the potential for reasonable growth. Our screen today will cover the best value plays in the technology hardware and equipment industry, as defined by my nifty Capital IQ screening software.
There are 109 such companies with market caps topping $500 million on major U.S. exchanges. They have an average forward P/E of 17.6. Here are my parameters:
- To stay away from bankruptcy risk, I used Damodaran's suggestion and considered only companies with total debt less than 60% of capital.
- In hopes of capturing a reasonable amount of growth, I looked at Capital IQ's long-term estimates and kept only companies expected to grow EPS at 5% annually or better over the next five years. Furthermore, I required at least 5% annualized growth over the past five years.
Of the 33 companies passing the screen, here are the 20 with the lowest forward price-to-earnings multiples.
|Super Micro Computer||$576||11.7||9%||17%|
Source: S&P Capital IQ.
To further stack the odds on your side, Damodaran says you can eliminate any companies that have restated earnings or had more than two large restructuring charges over the past five years. And if volatile swings in price cause you to lose sleep, consider only companies with betas of less than 1.
If you follow the technology sector, you might be interested in our special report, The Motley Fool's Top Stock for 2011. To see which little company we think is set to profit from the broadband Internet expansion -- it's absolutely free.
Fool analyst Rex Moore is on Twitter, but he's not a twit. He owns no companies mentioned here. The Motley Fool owns shares of Power-One, Western Digital, and Cisco Systems. Motley Fool newsletter services have recommended buying shares of Dell, Corning, and Cisco Systems and writing covered calls in Synaptics. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.