Although mathematically simple, taking a company’s price and dividing it by its earnings can tell an investor a great deal. The P/E ratio, as it is called, shows how much investors are willing to pay for a dollar of earnings. So, if a company has a stock price of $20 and earnings of $1.00, its P/E would be 20. Each dollar of earnings is worth $1 to the market. If that same company, trading at $20 per share, earned $0.50, however, the P/E would be 40—investors would be paying $2.00 for each dollar of earnings.
The price to earnings ratio is a valuation metric, helping to decipher if a stock is expensive or cheap. Although some use absolute metrics (a P/E over 20 is expensive, for example), P/E is most useful on a relative basis, comparing one company to its historical trends, to another company, or to an industry or market average. It is a way to measure that voting machine mentality of Wall Street about which Benjamin Graham wrote. The thought is that growth and momentum investors are willing to pay more for a dollar of today’s earnings to invest in a quickly growing company. A value investor, meanwhile, would prefer to wait until a company is “on sale” and trading at a low P/E multiple.
Every week Value Line publishes screens of the highest and lowest P/E ratios in the Index section of The Value Line Investment Survey. Although the common refrain is that value seekers should focus on the lowest P/E screen and growth and momentum investors should focus on companies with higher P/Es, this isn’t always true. The high P/E screen often turns up companies in the midst of a turnaround. So, while growth and momentum investors may find quickly growing companies on the high P/E list, value investors willing to sort through the 100 names that make the low P/E screen can also find some hidden gems.
A recent screen turned up rapidly growing companies like Take-Two Interactive Software (TTWO) and bebe stores, inc. (BEBE).
Take-Two Interactive Software
Take-Two is a publisher and developer of interactive entertainment software. The company consists of two wholly-owned labels, Rockstar Games and 2K. The software TTWO sells is used with various hardware platforms including Sony’s (SNE) PlayStation 3, Microsoft’s (MSFT - Free Microsoft Stock Report) Xbox 360, Nintendo’s Wii, and Apple’s (AAPL) iPhone. The company focuses on publishing a select number of high quality titles per year for which it can create sequels and build franchises. It develops most of its products internally and owns the intellectual property associated with most titles.
The company is coming off a difficult September quarter where the GAAP loss per share came in at $0.57, which compares negatively to the $0.09 generated in the year earlier period. The primary reason for the decline was a dearth of appealing titles in the quarter and the reliance on somewhat dated portfolio titles. Still, results were better than what Wall Street was expecting.
The company’s release pipeline becomes much more attractive in the subsequent quarters. In October, 2011 NBA 2K12 was released to outstanding reviews from the video game press. This franchise has long been a solid moneymaker, and we doubt this year will be an exception despite the continuing NBA lockout situation. Elsewhere, another installment in the BioShock series ought to arrive in mid-2012. This is one of the most critically acclaimed series of all time, and positive reviews for past titles have had a substantial positive impact on TTWO’s share price. The company has also announced that the next installment in the immensely successful Grand Theft Auto series, Grand Theft Auto 5, is currently under development. The stock price advanced 7% following the news. As a point of reference, this game’s predecessor, Grand Theft Auto 4 was the best reviewed title of all time (according to review aggregator Metacritic.com) and has sold 22 million copies in the 42 months it has been available. We believe investor sentiment will continue to improve leading up to the release date, which we believe will take place in a year’s time. However, these shares have significant exposure to potentially weak consumer spending levels this holiday season. Thus, more conservative investors ought to look elsewhere until consumer spending visibility improves.
bebe stores, inc.
bebe designs, develops, and produces a line of contemporary women’s apparel and accessories. The company’s target customer is a 21 to 34-year-old woman who seeks current fashion trends. Its product offerings include a full range of tops, dresses, active wear and accessories in the following lifestyle categories: career, evening, casual and active. It markets products under the bebe, BEBE SPORT, bbsp, and 2b bebe brand names through 252 retail stores, an on-line store (www.bebe.com), and 60 international licensee operated stores in 16 countries.
bebe stores continues to attract shoppers, posting an impressive 7% comp store sales gain during the September interim. The percentage of store visitors that actually made a purchase rose by 7%, which speaks to the brand’s rising popularity, good inventory management capabilities, and consumer’s willingness to spend money on fashionable clothes despite the weak macroeconomic environment. We also credit a strong merchandising team for the results. Looking forward, management indicated that markdown activity should be lower, and the company will begin to anniversary increased sourcing costs, so profitability ought to improve in the current quarter.
Although the stock’s lofty P/E of 40 times our forward earnings estimate may dissuade value investors, we think there may be some more room for the stock price to advance. Still, these shares have proven quite volatile in the past, so some may want to keep an eye out for a better entry point.
At the time of this article's writing, the author did not have positions in any of the companies mentioned.