The good old price/earnings (PE) ratio is widely used by professional and private investors alike as a kind of ‘rule of thumb’ stock measurement.
Used by the world, her husband and her dog, chances are that a simple “low PE = good; high PE = bad” approach only tells half the story, and you need to delve a lot deeper before making an investment decision.
That being said, a lowish PE is a good place to start.
When my colleague, Tom Howard, was working on his Rookie Investor portfolio, he asked me what a “reasonable” PE level is.
I responded something along the lines of “15 is the benchmark level for the market” because for most of my life as a City hack, that’s been the historical average.
Imagine my surprise when I did an internet search to find out what the PE ratio of the FTSE 100 is – it must be a state secret or Elton John has an injunction out on it, or something – and came across an article in the Telegraph’s Money section that suggested the Footsie’s PE ratio at the end of 2016 was an eye-watering 33.
The article went on to suggest that the high PE was a blip, caused by temporarily weak earnings from companies exposed to commodity prices and the rise in share prices since Donald Trump’s election.
I don’t believe it.
Not the reasons for the high PE; Donald Trump’s election.
I still don’t believe it, but I digress.
It's a CAPER (cyclically adjusted price to earnings ratio)
Using something called the “cyclically adjusted price to earnings ratio” (CAPE), which uses earnings over a 10-year period, the UK market’s CAPE drops to a more reasonable 16.
All of which is a long-winded way of explaining why using a PE of 15 as the upper bar on a stock filter is still a reasonable way of separating the “cheap” from the “fully valued”.
Another way is to compare a company’s net asset value (NAV), or book value, with its market capitalisation.
In this day and age I would not expect many companies to be trading below their book value – apart from just about every investment trust on the planet, obviously – but a price to book value of no more than 1.5 looks reasonable in identifying companies that might be on the cheap side.
Lastly, because companies are sometimes cheap for a reason, I like to see a rising trend in earnings per share.
For the purposes of this stock screening filter I went for five years of earnings per share (EPS) growth, with the most recent year showing growth of at least 10%.
I put that little lot into the pot and came up with seven stocks, including a couple of household names.
Here they are, listed in ascending order of price/earnings ratio:
- Sports Direct International PLC (LON:SPD)
- Vertu Motors PLC (LON:VTU)
- Telford Homes plc (LON:TEF)
- Augean PLC (LON:AUG)
- Barratt Developments (LON:MTVW)
- Henry Boot PLC (LON:BHY).
Join me next week as I run the rule over each of these to see whether they are truly the undervalued growth machines they appear to be.