One of the most commonly used metrics for determining a company’s worth is the price-earnings (P/E) ratio. This ratio is calculated by dividing the current stock price by the trailing 12-month earnings per share and is closely watched by investors as it links recent earnings success to future company performance. Models exist to help determine if a company’s P/E ratio is reasonable, with the relative price-earnings ratio approach comparing a stock’s P/E ratio to that of the market or industry.
AAII’s P/E Relative screen has consistently outperformed the S&P 500 index since inception, generating compound annual price gains of 13.8% compared to the S&P 500’s 6.3%. The screen typically includes 36 passing stocks with an average turnover of 21.3%, providing investors with potential opportunities to capitalize on undervalued stocks.
The price-earnings relative is calculated by dividing a company’s P/E ratio by that of the market, indicating whether a company’s valuation tends to be higher or lower than the market average. Changes in the price-earnings relative can signal shifts in market expectations about a company’s future earnings potential and help investors identify mispriced securities. Screening criteria in AAII’s Stock Investor Pro allows investors to screen stocks based on the price-earnings relative.
To calculate the price-earnings relative, investors need the current market P/E ratio and the five-year average P/E relative for the stock being analyzed. By utilizing these values, investors can determine a fair market valuation and identify potential undervalued stocks. Screening for undervalued stocks based on P/E relatives involves filtering stocks on major exchanges with positive earnings per share over the last five years and excluding extreme outliers in price-earnings ratios.
Investors are encouraged to assess a company’s earnings growth patterns to determine if the growth is sustainable and evaluate potential factors influencing growth. Price momentum and earnings revisions can act as catalysts, attracting attention to undervalued stocks and driving stock price movements. By applying rigorous screening criteria and conducting thorough due diligence, investors can identify companies with the potential to revert back to typical valuation levels.
In conclusion, using the price-earnings approach to screen for undervalued stocks can help investors uncover opportunities in the market. However, caution is advised, and careful analysis of a company’s fundamentals and industry environment is crucial before making investment decisions. The stocks that meet the criteria of the approach do not represent recommendations, and investors are urged to perform their own due diligence before making financial decisions.
