Columns R – T – Price to Earnings Ratio

Cameron : Column R is the price to earnings ratio. The P/E is first thing everyone learns when they start dabbling in the share market. Now this is straight up financial data. We can get this off of any data source. 

Well, let’s talk about the P/E, Tony. You’ve said in the past that it’s a little bit like price to cash, kind of an indication for how long it will take for the business to provide enough earnings to neutralize our purchase price. But the concept of earnings is a little bit fluffier than net operating cash and can be manipulated in the financials.

Tony : Correct. That’s exactly why I use operating cash to share price as the ratio, rather than the price to earnings ratio. We don’t use the P/E in terms of a direct indicator of whether a stock is the right price or not. We use the P/E trend

Cameron : Well, we do give this question a score. If the P/E is less than the yield, you’ve told me in the past, is just an observation that you’ve made as an indicator of value. 

Tony : Yeah, exactly. So again, if you think of a company paying out a dividend, it’s going to have the view that they can keep doing that going forward. And if the P/E is less than the yield, then it’s going to be cheap. So we’re seeing a company which has all likelihood of continuing to pay a dividend, which means in all likelihood it’ll stay in business. But if you can buy it when the P/E is less than the yield, and the yield is probably going to be around 4% or 5%, then the P/E is very, very low.

Cameron : Okay. And so this is column S for the checklist is the P/E less than the dividend yield. We give it a one for a positive and blank for a negative.

Tony And if the company doesn’t issue a dividend, or doesn’t have a P/E, we also give it a blank. It’s gets an extra score if it scores a positive, but we don’t punish the company if it doesn’t meet this metric. 

THE LOWEST P/E

Cameron : Okay, let’s talk about column T, which asks: is it the lowest P/E in the last three years? People can find the P/E history in Stock Doctor. So we want to go back six halves (i.e. six financial reporting periods) to get three full financial years. Is that right?

Tony : Correct. 

Cameron : We give it a score of two if the current P/E is the lowest, a zero if it’s not the lowest, and a negative one if it’s the highest.

Tony : That’s right. 

Cameron : Do you want to talk us through why?

Tony : Again, it’s an indicator of value. Using three years is a bit arbitrary but the thinking behind it was, if you go back too far, the company could have evolved over time and the P/E could have changed, but in the last three years and all things being equal, it’s probably roughly the same sort of company it was three years ago and so we can compare its P/E history. And if the P/E is the lowest in that three-year period, that’s a sign of value. And if it’s the highest in that three-year period, that is probably a sign of it being overvalued. 

Cameron : So if it has the lowest P/E in the last three years, it’s an indicator that the stock is currently undervalued by the market.

Tony : Correct.