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HistoricalPEGuy (58.08)

Explaining the Historical PE Mentality

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September 08, 2007 – Comments (5)

I've now been asked on numerous occasions as to why examining the Historical PE of a stock makes sense.  The criticisms have actually been quite good.

- "This sounds like reversion to the mean to me.  Statistical mumbo jumbo"
- "Just because a stock is at a low for its historical PE doesn't mean buy it"
- "The stock market isn't that easy"

These are great quotes and really speak to the heart of value investing.  I am not a pure value investor, but I can't help but pick up stocks that have been beaten down for no reason or are cheap beyond belief.

The key to the Historical PE mantra is finding companies that are rock solid.  To start, it doesn't even make sense for companies that aren't profitable.  That eliminates quite a few.  So if your going to use this methodology, start with bellweather stocks that grow earnings consistently over time and have a strong, no, unflappable record of growth.  They are out there - MMM, GE, KO, BA, etc.  They don't have to be a DOW stock, but that's a good place to start.  Here, it really is reversion to the mean.  Given that the company is totally solid and will continue to drive profits, why not buy when its cheap?  But how do you define cheap?  Its not the stock price - that's irrelevant - its the price as compared to earnings.  Earnings drive the market and if you don't think so, you are not an investor, you are a gambler.

Get it?  If the earnings keep climbing at a steady pace, then PE ratio is the perfect metric.  Right, but earnings don't grow steadily.  They can bounce around.  Sometimes, the PE ratio is low because the earnings estimates are in the toilet.  Pure Technical analysis is like staring at your feet during a marathon.  It works for a little bit, but not a good long term methodology.  The company you are investing in absolutely must have rock solid growth.  Fact is, it won't work for many companies.  Homebuilders are a great example.  Historically low PE, that's for sure!  Rock solid growth?  Not really.

So what stocks satisfy this criteria?  Where should I put my money?  Well its not that easy, but we can take a look at some possible candidates.

Here are two examples - MMM (which is currently at an all time low) and Citigroup (another sitting pretty).  Do you really think that these companies will be unable to drive future growth opportunities?  Is there a sudden shift in the markets that has totally redifined these businesses for years to come?  No.  Both will have growth spurts and lackluster years.  But you can take advantage by realizing that the historical PE is at a low.  One day it will be higher - history proves that - with earnings  much higher as well.  Nope, not a 10 bagger, just stocks that will beat the market over time.

Go to www.bigcharts.com and use the lower indicators.  They have historical EPS and PE ratio.  Look for the stairstep growth in EPS and the fluctuation in PE.

While you might not agree with the methodology, at least you learned something.  Fool on....

-- HPEGuy

5 Comments – Post Your Own

#1) On September 08, 2007 at 12:40 PM, rd80 (97.75) wrote:

Great post. 

Not only gives a couple of stock pitches, but you explain the methodology and your reasoning behind it.

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#2) On September 14, 2007 at 1:01 PM, TMFHelical (98.76) wrote:

PEguy,

 You may be interested in this sight which runs a script to gather and display Morningstar charts - including P/E data.  This was prepared by Rharmelink and posted on the BMW boards (and he said OK to share).

http://ogres-crypt.com/php/chart-mscf.php

It clearly shows 3M for example trading at a P/E discount to historical values.

http://ogres-crypt.com/php/chart-mscf.php?s=mmm

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#3) On September 14, 2007 at 4:56 PM, HistoricalPEGuy (58.08) wrote:

Thanks, HelicalZz.  Very neat.  Be sure to check out bigcharts.  You can get historical P/E information to the date... 

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#4) On September 14, 2007 at 5:21 PM, Ludraman1 (< 20) wrote:

I work for a very fast growing company that has gone from nothing to $500m in revenues; if the company stopped investing every penny of income, as it was earned, back into the business, it would not be where it is today. The P/E was used by a lot of people (including employees) as a basis for saying the company was overvalued. Bare in mind when you say something is "overvalued" based on the price the market has assigned it, you are better against a lot of institutions who have studied the company, the management, the financial performance and the basis for it.

 The big institutions set the price for most shares so if you believe it is "over valued" you better have a fuller explanation than to say the P/E ratio is high ( same with the PEG ratio).

 

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#5) On September 21, 2007 at 10:40 AM, HistoricalPEGuy (58.08) wrote:

Ludraman1 - Historical P/E analysis is not for small upstart companies doubling in size every couple of quarters!  P/E is almost meaningless at high growth companies.  Look at CMG.  I am not sure you can use P/E here as the business is growing so fast, its hard to benchmark its P/E to figure out what "cheap" means.

However, take a look at MMM.  The earnings are pretty consistent with a nice stair step type of growth over many years and decades.  Now, we have something to measure its current P/E - its own history.  There is no such things as a good P/E - only relative to some benchmark that actually makes sense.  Is 11 a good P/E?  Can't tell by itself.  Look at peers.  Look at history.  

In the end, P/E, by itself, cannot be used to determine if a company is overvalued or not - and definitely not for a high flying growth company whose P/E is all over the place or more often than not, negative!

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