Sudha, a housewife had just returned from her weekly kitty party session. She immediately turned on her computer at home and went to one of the trading websites. She was impatient. Mrs. Kumar at the kitty party had just mentioned how she had tried her luck at stock investing. She explained the thumb rule of of finding stocks at low P/E’ s being a good bet and went on bragging about how she had a earned a good Rs. 10000 in one month. As soon as Sudha heard this her thoughts were only on getting home early & finding stocks with low P/E s to invest in. She immediately logged on to one of the financial trading websites & looked for stocks that traded at price to earnings ratio less than 10 (a ratio Mrs. Kumar had mentioned as being a good buy.) She was excited to find some 50 stocks trading at a P/E of less than 10. Wow she thought!!! She was going to be rich soon too. She invested randomly in the top 10 stocks in the list. So what do you think happened to Sudha after 6 months…… Let’s see…
Well six months later, when Sudha checked her portfolio, Sudha realized she was in deep trouble. Forget high returns, 9 out of her 10 investments had reached pitfall levels. She was in heavy losses. After studying the stocks for a while she realized that most of the companies she had invested in were small risky companies, with extremely erratic earnings. She realized being undervalued was not the reason for the stocks having a low P/E. The main reason was the sudden jump in earnings, in most cases due to the sale of an outside business asset.
A stock that trades at a low P/E is not always cheap!!! P/E is the market price of the share divided by the current earnings per share. The problem mainly lies in the earnings per share. The number of outstanding shares in the market too brings a difference in the P/E ratio.
Companies having a history of erratic earnings will trade at low P/E s when they witness upward swings in their earnings. These are high risk stocks and investing in them becomes more of a gamble. Consider the stock below:
Year 2006 2007 2008 2009
Stock Price 23 30 25 15
Earnings 0.72 4 0.5 0.32
P/E 32 7.5 50 46.88
Many innocent investors would have been caught in the trap in 2007, just by looking at the attractive P/E. Any investment in the year 2007 would have given nothing but losses to the investor for the next 2 years.
Consider the example of TVS Motors – In March, 2003 it was trading around Rs.40 and at a low P/E level of 7.5. Seems like a great candidate for applying the P/E thumbrule, doesn’t it? However March 2003 was a great time for the company with a 129% increase in profits – the result a seemingly attractive low P/E. However investing in the company in March 2003 would have given nothing but losses to an investor over a 5 year period. For the next 5 years, the company saw its profits falling & in March 2008 the company’s stock price was Rs. 34 and was trading at a P/E of 28. Buying at a low P/E of 7.5 and selling at a high P/E of 28 brought nothing but losses to the investor.
The other likely reasons for a company trading at a low P/E, could be the company has had a history of trading at a low P/E. Even its industry P/E plays a role here. Probably the companies in the industry have had low P/E trends.
Even when I initially entered the world of stock investing, I always used to end up considering stocks with a low P/E, conveniently assuming that they are cheap. It was only when I was guided by my colleagues at the company I work & they introduced me to the concept of value investing I realized that there are a number of myths in the stock investing world; one of the most dangerous ones being that a stock with a low P/E is a cheap buy.
Hence, for beginners in the stock investing world, beware of stocks with unusually low P/E s. There could be many reasons for this. Always check on the past fundamentals of the company, study why the market is undervaluing the stock; maybe the company is up to some goof up etc. Don’t always use the thumb rule of low P/E and invest blindly!!!
Source:http://stockshastra.moneyworks4me.com/learn/a-stock-that-trades-at-a-low-pe-is-not-always-cheap/
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