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Why price-to-earnings ratios matter (and 5 low P/E stocks worth a look)

Stocks are driven by earnings, and knowing how to interpret those earnings is crucial.

Learning how to gauge a stock’s price-to-earnings ratio can help empower your stock picks. Here’s how price-to-earnings ratios work, along with five low P/E stocks to consider.

What is a price-to-earnings ratio?

A stock’s price-to-earnings ratio, or P/E ratio, directly reflects a stock’s earnings relative to its price. Essentially, it expresses how much current investors are willing to pay for $1 of profit from that company. Investors use this metric to compare stock valuations and to help them gauge if a stock is trading at a discount.

In short, a low P/E stock is considered inexpensive. A high P/E stock is considered expensive.

You can also use this valuation tool on a trailing basis from the previous year’s earnings. Or you can use it as a forecasting tool for future valuations. These variations of P/E ratios are called the trailing price-to-earnings ratio and the forward price-to-earnings ratio.

Calculating the P/E ratio

A stock’s P/E ratio can be calculated by dividing its market price per share by its earnings per share (EPS).

For example, let’s say Company X’s stock currently trades at $10 per share. Last year, it reported earnings of $1 per share.

When we divide Company X’s $10 share price by its $1 per share in earnings, we get a price-to-earnings ratio of 10:1 — meaning the stock is trading at 10 times the earnings on a trailing basis.

Now, let’s say we have forward guidance from the company. Company X says it expects to report earnings of $5 per share for 2021.

To find its forward P/E ratio, you use the same equation with the new earnings per share figure: $10 share price divided by $5 per share in earnings, which gives us a price-to-earnings ratio of two.

The stock is trading at two times the earnings on a forward-looking basis.

*Note: companies with negative full-year earnings will not have calculable P/E ratios.

P/E ratios by sector

Keep in mind, a “cheap” stock that trades at five times the earnings isn’t necessarily a better deal than a “pricey” company that trades at 30 times the earnings. And that’s partly because different sectors trade at inherently different valuations.

Growth industries like tech garner much higher premiums for stocks because of their growth potential. Investors are willing to accept bigger P/E ratios for Amazon (AMZN) because it delivers above-average annual growth compared to a mature blue-chip stock like JPMorgan (JPM).

When evaluating a stock’s P/E ratio, consider the ratios prevalent across the entire sector or industry. This way, you’ll have better context for understanding the ratio.

Comparing companies by P/E ratios

So, how can P/E ratios help you compare the value of two different stocks? Let’s take a look at another hypothetical example.

Let’s say Company A and Company B both belong to the tech sector and sell shares for $20 apiece. At first glance, you might assume the stocks are equally valuable. But if we dig into each company’s P/E ratio, we uncover a different story.

Company A reported earnings of $5 per share, while Company B reported earnings of $10 per share. This means Company A’s P/E ratio is four, while Company B’s P/E ratio is two. In this instance, even though their shares are priced identically, it would be more practical to buy shares from Company B, as investors receive $10 of earnings per share purchased instead of the $5 of earnings per share offered by Company A.

Limitations of P/E ratios

Price-to-earnings ratios matter but aren’t infallible — and they’re far from the only metric you should rely on to assess the value of a stock. There are numerous elements a P/E ratio doesn’t account for:

  • Misleading balance sheets. An unhealthy balance sheet with lots of debt or weak cash flow may influence a P/E ratio.
  • Major market events. Events that impact the economy may cause drastic fluctuations in stock prices, contributing to misleading P/E ratios.
  • Outsized or undersized growth. Investor may be willing to pay more for a company growing quickly, so it’s worth know the PEG ratio as well as P/E. Price/earnings to growth ratio can be calculated by dividing a stock’s P/E ratio by its earnings growth. This formula uses the same information as the P/E ratio while simultaneously factoring in a company’s earnings growth.

5 stocks with low P/E ratios

When selecting stocks with low P/E ratios, it’s important to remember that just because a stock is cheap doesn’t mean it’s a keeper. These are 5 stocks carrying low P/E ratios (based on the most recent full fiscal year results) that have growth potential for 2021.

1. General Motors (GM)

  • Recent price: $59.66 stock price on 4/12/2021
  • P/E ratio: 13.92
  • Company details: One of the oldest automakers, General Motors follows the trend of most car stocks, which have been relatively cheap relative to earnings since the financial crisis of 2008.

2. CVS Health Corp (CVS)

  • Recent price: $74.46 stock price on 4/12/2021
  • P/E ratio: 11.78
  • Company details: Pharmacy chain with thousands of stores. A well-developed company, CVS has had mixed annual earnings growth over the last five fiscal years, which could contribute to its lower valuation.

3. Big Lots (BIG)

  • Recent price: $67.87 stock price on 4/12/2021
  • P/E Ratio: 9.31
  • Company details: Retail chain focused on affordable goods across food, home items, electronics and more. Annual earnings growth has been somewhat slow over the last five years, while the company saw good sales growth in its last fiscal year. Overall, this could represent value for shareholders if its current trend continues.

4. Best Buy (BBY)

  • Recent price: $121.77 stock price on 4/13/2021
  • P/E ratio: 16.5
  • Company details: Retailer focused primarily on electronics, Best Buy carries one of the higher P/E ratios on this list at 16.5 but falls below TDAmeritrade’s listed specialty retail industry average of 39.14. It is one of the last remaining brick-and-mortar tech retailers that continues to perform well.

5. Allstate Corp (ALL)

  • Recent price: $118.75 stock price on 4/13/2021
  • P/E ratio: 5.83
  • Company details: Large-cap insurance company based on property and casualty insurance, life insurance, health insurance and more. In all, the stock carries a low P/E ratio because the company’s top-line growth has been slow over the last few years, while a declining share count and emphasis on driving earnings per share have driven the price-to-earnings ratio down.

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To buy any of these or other stocks, you’ll need a brokerage account. Most broker sites and apps also include tools to make it easy to look at data like stock P/E ratios.

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Disclaimer: The value of any investment can go up or down depending on news, trends and market conditions. We are not investment advisers, so do your own due diligence to understand the risks before you invest.

Bottom line

When selecting stocks for your portfolio, P/E ratios may help inform your picks. But this metric isn’t foolproof, and P/E ratios tend to fluctuate by sector. To invest, review your brokerage account options to find the platform best equipped to help you meet your investment goals.

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