Saturday, June 23, 2007

Is buying high earnings-to-price (or low PE) stocks a good strategy?

Reader's Question: Is buying stocks with high earnings-per-share (EPS) as a percentage of stock price a good investment strategy? I am considering investing in a Bombay-listed Indian bank (current share price of 85 rupies) whose EPS has been about 15% of share price for the past three years. If this trend continues, will I be able to receive my initial investment back through EPS over the next six to seven years? Will all the EPS be deposited into my bank account?

Low PE: An Entree into Low PEG

We can restate your main question in more familiar stock market jargon by inverting your earnings-to-price percentage to get a price-to-earnings ratio: Does buying stocks with low price-to-earnings ratios (P/E) produce higher returns? A wealth of literature exists on this topic of low-PE stocks within the framework of value investing. Rather than rehash the basics, I cite an article available online--This Stock Is So Cheap! The Low Price-Earnings Story--for your edification and perusal. The author of the article draws this conclusion:

The conventional wisdom is that low PE stocks are cheap and represent good value. That is backed up by empirical evidence that shows low PE stocks earning healthy premiums over high PE stocks. If you relate price-earnings ratios back to fundamentals, however, low PE ratios can also be indicative of high risk and low future growth rates. . . . [A] strategy of investing in stocks just based upon their low price-earnings ratios can be dangerous. A more nuanced strategy of investing in low PE ratio stocks with reasonable growth and below-average risk offers more promise, but only if you are a long-term investor.


To the above, I would add that I tend to favor "low PEG" as a more useful indicator of potential upside than low PE. Since PEG is the "super-ratio" of price-to-earnings ratio divided by earnings growth rate ("PEG" = PE/G, where "PE" = P/E), PEG embodies a growth component that PE lacks. In other words, by considering low PEG stocks, investors can concurrently select both good current value (relatively low PE) and good expected growth (relatively high G). For a discussion of stock returns, EPS growth, PE and the importance of low PEG, please have a look at an earlier blog entry.

Investment Cash Flow: Fixed-Income vs. Stocks

If you could find a fixed-income investment that pays 15% current interest (some junior mortgages on real estate and certain junk bonds pay this type of return, though both involve considerable payment default risk), your annual scheduled investment cash flows would be what you have in mind: 15 dollars (or rupies if in India) for every 100 dollars (or rupies) of principal invested. Further, given a seven-year maturity, you would (assuming the borrower does not default) receive more than your initial investment back in interest payments (7 years x 15% = 105%), which, when combined with your principal, would actually amount to total cash flows of 205% (105% interest + 100% principal) over the full holding period.

Unlike fixed-income investments, stocks do not have any pre-scheduled set of cash flows. Although you might be able to buy a stock at an earnings-to-price percentage of 15% (PE of 6.7), there is no direct linkage between your investment cash flows and the company's earnings. Instead of making pre-scheduled payouts to equity investors, companies pay periodic (usually quarterly or semiannual) dividends which are typically some fraction of earnings. Based on earnings results, availability of cash flow and company policy, management can raise or lower dividends from one period to another.

With the exception of very long, multi-decade investment horizons, the primary determinant of your returns from stock investing will be, not dividends, but the terminal market value of the stock when you sell it (or simply wish to calculate your mark-to-market "paper profits" without actually selling). The uncertainty of the future price of a stock is what makes stock investing risky business but also has the potential of delivering great financial rewards to those who succeed over the long haul.

In your example of buying an Indian bank stock (possibly Andrha Bank?) at 85 rupies, your investment cash flows would consist of relatively small dividends, amounting to about two or three rupies per share per year. Whenever you decide to sell your shares, you will receive whatever the market price is at the time of sale, which, of course, can be either higher or lower than 85 rupies and will typically become the main component of your net profit or loss over your holding period. Both dividend payments and proceeds from sale of your shares will end up in your brokerage account and can then be transferred to your bank account if you so desire.

19 Comments:

Anonymous Anonymous said...

Market risk is perceived to be the price we are required to pay to enjoy the higher long-term returns historically available in common stock investing. Prudent investing, however, does involve trying to reduce idiosyncratic risk - that is, reducing the risk inherent in the ownership of individual securities. The definition of quantity theory of money is the proposition that a change in the growth rate of the money supply brings an equal percentage change in the inflation rate.

11:29 AM, June 25, 2007  
Anonymous Anonymous said...

When looking at PE ratios for an indication of value, one must be aware of what type of company he is examining and at what point in the buisness cycle we are in. Low PE's or PEG's are often a sign of value in classic growth companies. However when looking at cyclicals it is often near the top of the cycle when companies look very cheap. This is evident when looking at commodity based industries like oil or steel where so much of their earnings are based on that commodities curent price. When the commodity is low priced, the stocks will sport high PE's due to the absence of earnings. But when the price of the commodity goes up, earnings follow and PE,s go down. When looking at cyclicals past performance the stocks will boost high PE,s right before big moves up and low PE's right before big moves down. If determining value was as simple as looking at a PE or PEG ratio, we would all be rich.

11:05 AM, September 12, 2007  
Blogger Palinure Team said...

hello my friend's

check our blog , it's about one of the safe and best online investment company.

palinureteam.blogspot.com

good luck

9:43 AM, October 23, 2007  
Blogger Vivaan said...

Here are another 3 high revenue generated blogs

http://3dsnaps.blogspot.com/
http://interviewingquestions.blogspot.com/
http://brahmathoughts.blogspot.com/

Thanks
Vivaan

6:23 AM, June 07, 2008  
Blogger shayan.iranboy said...

hi im from iran i have alot of epoint but i cant cash and transfer to bank
i can transfer to u.i want to sell my epoint under price 10000epoint=9000$
thnx
bye
shayan.iranboy@gmail.com

10:27 AM, August 02, 2008  
Anonymous Paige said...

Adding the G in PE calculation is a really good idea. I have always used PE more as a filtering criteria rather than a selection criteria. By its very definitionP/E helps tell you what stocks are really expensive, so you can avoid them and filter them out. But adding G will help determine whether it is attractive enough to really buy into.
Thanks for your insight into this!

3:52 AM, August 26, 2008  
Anonymous Anonymous said...

To earn free money at home 100% free and easy and also payment proofs visit http://freedollors.webnode.com

12:00 PM, October 01, 2008  
Anonymous Anonymous said...

It is easy now for girls and boys to make money online just visit us

www.-money-making-site.com

Thanks

9:28 PM, December 26, 2008  
Anonymous MoneyMakerOnline said...

thank for useful post. already bookmarked your site. wating for more post like this

3:45 AM, April 25, 2009  
Anonymous Golden Trade Investment said...

definition of quantity theory of money is the proposition that a change in the growth rate of the money supply brings an equal percentage change in the inflation rate

3:47 AM, April 25, 2009  
Anonymous Matt Smalls said...

The process to invest in the low risk investments is facile. And getting started in this investment is a smooth process. Even an inexperienced investor can easily invest in this investment.

4:35 AM, July 09, 2010  
Anonymous Anonymous said...

Another thought regarding commodities is to consider mining properties. Strategies exist both from a mining industry perspective and from a real estate perspective in the case of controlling a mine or actually owning patented mining land. There are several sites out there but there is a free site with a decent amount of mines for sale be it gold, silver, copper, you name it. Go to Mines For Sale at MineListings.com

4:42 PM, August 24, 2010  
Anonymous options trading said...

very inspirational blog.i love reading your blogs,so glad you've shared this.
very interesting.thanks for sharing,
i really love all the information that stated in this blog.
options trading

4:41 AM, March 23, 2011  
Anonymous Stock Tips said...

It was a awe-inspiring post and it has a significant meaning and thanks for sharing the information.Would love to read your next post too......
Thanks
Regards
Stock Tips

2:11 AM, April 18, 2011  
Anonymous Sharelord said...

This is obviously one great post. The information are very insightful and helpful. Thanks for sharing all of these.

11:43 PM, July 13, 2011  
Blogger Paul said...

I really appreciate your post. It gives an outstanding idea that is very helpful for all the people on the web.
Thanks for sharing this information and I’ll love to read your next post too.
Regards,
commodity tips,stock tips,nifty tips

2:59 AM, January 25, 2012  
Blogger Paul said...

thanks for this post. This post makes a great point about focusing your efforts.

stock tips,equity tips,stock market india | Currency Tips,Forex trading Tips,Forex Pairs | commodity tips

3:08 AM, June 16, 2012  
Anonymous Stock Tips said...

Nice piece of work, the article is arrange in very good manner, I loved the way it is written. It stands
apart from the crowd owing to the matchless taste Keep it up.

4:50 AM, August 31, 2012  
Blogger Richard Jonson said...


I was working and suddenly I visits your site frequently and recommended it to me to read also. The writing style is superior and the content is relevant. Thanks for the insight you provide the readers! Thanks for such an interesting article here.
Call Option || Option Tips || Stock Option Tips || Options || Nifty Options

10:24 PM, January 14, 2013  

Post a Comment

<< Home