The following article is based on a chapter from Aswath Damodaran's book Investment Fables.

What makes a stock cheap?

There are many things to look at when determining whether a stock is cheap: the price, market cap, earnings per share, or dividend yield. One commonly used metric is the price-to-earnings ratio (P/E), which allows investors to compare companies across a level playing field.

Keeping it simple
While it is not the end-all-be-all metric, the beauty behind the P/E ratio is its simplicity. Logic would argue that a stock trading at a lower P/E than its peers could be mispriced and therefore a potential value. Finding mispriced stocks is a fundamental principle of value investing, and there is plenty of evidence that low-P/E stocks outperform higher-P/E stocks over the long haul.

Another reason why low-P/E stocks can make attractive investments is that they offer a nice alternative to bonds. Although stocks do not have coupon payments like bonds do, they do have an expected earnings yield. It is simply the net earnings per share divided by the share price, or the inverse of the P/E ratio. Therefore, stocks with low P/E ratios have high earnings yields. As an example, a company that has a P/E of 12 has an earnings yield of 1/12, or 8.3%.

Measuring value
Unlike a bond, though, the earnings yield is not guaranteed. The only way for investors to cash in on earnings is when companies pay them out through dividends. Below are some low P/E stocks with their corresponding earnings and dividend yields.

Company

CAPS Rating
(out of 5)

P/E*

Earnings
Yield

Dividend
Yield

Molson Coors (NYSE: TAP)

*****

10.7

9.3%

2.3%

Chubb (NYSE: CB)

*****

8.3

12.0%

2.9%

Merck (NYSE: MRK)

****

6.6

15.2%

4.1%

Banco Santander (NYSE: STD)

***

9.1

11.0%

4.0%

Travelers (NYSE: TRV)

***

8.4

11.9%

2.5%

Sempra Energy (NYSE: SRE)

***

10.5

9.5%

3.2%

BP (NYSE: BP)

*****

10.4

9.6%

6.1%

Source: Motley Fool CAPS.
*Based on earnings from the past 12 months.

These companies certainly look cheap, but how can we know for sure? The best way to answer this question is to break down the P/E ratio into its individual components.

Running the numbers
As mentioned above, the P/E ratio is simply the value of a company divided by its annual earnings. Using the dividend discount model of valuation, the value of a company can be calculated by finding the current value of its future dividend payments. For companies that don't pay dividends, free cash flow is the next-best estimate. If we assume that future dividends grow at a constant rate forever, the value of a company can be expressed as follows:

Price = Expected Dividends per Share / [Cost of Equity-Expected Growth Rate]

The cost of equity is simply the return investors require for investing in a particular company. If we divide both sides of the equation by earnings per share, we get

P/E = [Expected Dividends per Share / Earnings per Share] / [Cost of Equity-Expected Growth Rate]

Expressed this way, the equation above allows us to dissect why a low-P/E stock may not be the best investment idea. Companies with a high expected growth rate will have higher P/E ratios as the denominator goes closer to zero. Along those same lines, companies with more risk have a higher cost of equity and therefore a lower P/E ratio as the denominator increases. For these reasons, a low-P/E stock may be nothing more than an investment in a high-risk, low-growth company.

Incorporating other factors
Despite the evidence that low-P/E stocks outperform their high-P/E counterparts, it's not enough to simply pick stocks with the lowest P/E ratio. It is important to look at a company's risk and growth potential along with the quality of its earnings.

Risk can be defined several ways. Some investors use beta to measure risk, while others use stock rankings. For the long-term investor, the biggest risks are a company's inability to pay off debt and sustain operations during times of trouble, which can lead to bankruptcy. Some metrics that quantify this risk are the debt-to-equity and interest coverage ratios. Whatever your measure of risk is, minimizing it when investing in low-P/E stocks greatly increases your chances of success.

The second thing to bear in mind when investing in low-P/E stocks is their potential growth rate. One can look at the historical growth or estimates of future earnings growth. Some companies with low P/E ratios could be coming off several years of high growth but may have low growth potential for a variety of reasons. Oftentimes, companies that trade at low P/E ratios are in mature industries with very little growth potential. Because the past is not always a good indication of the future, and analysts' estimates are still only estimates, it is important to look at both historical growth and future growth potential when screening out low-P/E stocks.

Finally, realize that there are plenty of accounting tricks that can be used to overstate or understate earnings. Always be cautious of companies that consistently restate earnings or frequently take one-time charges or benefits. Also make sure there is not a large disconnect between earnings and revenue growth. A company may be able to show a 15% growth in earnings while only producing a 5% growth in revenue, but this is a short-term phenomenon that is not sustainable.

Get real value
So remember, when you see a stock trading at a low P/E ratio, don't immediately assume it's a bargain. Consider the growth potential, the risk of the company, and the quality of its earnings before you decide whether it is the best bang for your buck.

Stocks with low P/E ratios are one type of bargain that the Motley Fool Inside Value team looks for. But there are plenty of others. To find out how we use the entire trove of value investing tools to beat the market, simply click here for your free 30-day trial.

This article, written by Elliott Orsillo, was originally published on Jan. 12, 2007. It has been updated by Dan Caplinger, who doesn't own shares of any of the companies mentioned. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.