One way in which stocks are valued is the price to earnings ratio, commonly abbreviated as P/E or p/e. It is a fairly simple calculation that divides a stock’s price by the company’s earnings per share for a given 12-month period. The logic of the ratio is that by owning a share of a company you are, arguably, buying the future stream of earnings the company generates.
If a company’s earnings are growing strongly, investors might logically assume that today’s earnings are worth more because of the potential for future growth. Conversely, if a company’s earnings are growing slowly or unevenly, it wouldn’t make logical sense to pay a premium. This last statement highlights an important aspect of the P/E ratio—by itself it provides minimal information. To properly use the P/E as a valuation tool, it must be compared to something.
In many cases, an individual P/E is compared to the average P/E of the broader market. Value Line publishes the P/E of the market each week for this very purpose. Moreover, each Value Line research report contains both the actual P/E and the company’s relative P/E. A relative P/E above one suggests a valuation level above that of the broader market and a relative P/E below one suggests a valuation level below that of the market. Another common comparison is to consider the current P/E versus a company’s historical P/E ratio. This information is provided in the historical section of the Statistical Array on each Value Line report. Price to earnings ratios can also be compared between peers, to spotlight the companies in an industry that are trading at a high price and pinpoint the ones that are trading relatively inexpensively. As a valuation tool the P/E is very valuable and should be a part of every investors’ toolkit.
Very often, a P/E is best used to simply cut companies from a list of research candidates. It is, indeed, a quick way to pull out companies that are trading relatively cheaply from a much wider group. To this end, each week The Value Line Investment Survey contains a listing of the 100 companies with the lowest Price to Earnings ratios out of the approximately 1,700 followed by the Service (it is paired with a similar screen for the highest P/Es). For value-oriented investors, this list of low Price to Earnings ratio stocks is a great place to start looking for investment ideas. Below are a couple of companies that were recently found on this list, namely Rio Tinto plc (RIO) and Cirrus Logic (CRUS).
Rio Tinto plc
Rio Tinto, based in the United Kingdom, is the world’s second largest mining company behind BHP Billiton (BHP). The company mines and processes a diversified range of minerals that make aluminum, copper, iron, etc. Around half of Rio Tinto’s revenue and over 80% of its income stems from iron ore extraction, a key ingredient in steel. It also produces energy assets, such as coal and uranium, plus industrial minerals, like borax, titanium dioxide, and salt. The company’s operations are located across the globe, with significant concentration in North America and Australia, and smaller presence in South America, Asia, Europe, and South Africa.
Rio has hit a few bumps in the road of late. Former chief Executive Tom Albanese recently resigned after the company revealed that it will post a $14 billion write-down of goodwill, which was added to the balance sheet after the acquisition of certain coal and aluminum assets. The change in asset valuation indicates that Rio paid too much for Alcan and Riversdale Mining. We believe Mr. Albanese’s replacement, Sam Walsh, will do well to get the miner focused on core operations. Mr. Albanese’s previously headed up Rio’s iron ore business and is looking to expand it further.
In addition, the company has agreed to sell certain facilities in South America. Exiting less profitable businesses ultimately makes sense for Rio Tinto, since this reduces liabilities. What’s more, capital will be available for more-desirable projects. Notably, the company spent more than $7 billion on expansionary initiatives during 2012.
The stock has regained some lost ground of late, arising partly, it seems, from better-than-expected economic figures in China (a huge consumer of commodities) and the change in leadership. Furthermore, capital appreciation potential over the 2015-2017 horizon still looks appealing, when compared to the Value Line median. But prospective investors should be aware that these shares can be quite volatile, at times, reflecting fluctuations in the prices for various metals as well as the global and Chinese economic outlooks.
Cirrus supplies high-performance analog circuits and advanced mixed-signal system-level chip solutions. Products sold under the company’s name and Crystal brand enable system-level applications in mass storage, audio, and precision data conversion. Sales from outside the United States currently account for more than 85% of the company’s total.
Overall results have been good thus far in fiscal 2012, which ends on March 31st. We attribute that partly to a good performance from the Audio Products division, brought about by healthy demand for portable products. Notably, the company continues to benefit nicely from the success of its biggest customer, Apple (AAPL), which comprises nearly 80% of total revenue at present. On the negative side, the Energy Products group has suffered from diminished volumes of power amplifier and power meter products. Too, profits have been constrained somewhat by a big ramp-up in R&D spending in order to support multiple new product launches.
The stock has fallen considerably over the past few months. We believe that movement is the market’s overreaction to management’s tempered (but still decent) near-term outlook for Apple. We think there is little risk that Cirrus will lose designs in future Apple products. In fact, its presence should only expand as new devices are revealed.
Importantly, Cirrus is set to release December quarter earnings after market close on Thursday January 24th; investors may wish to remain on the sidelines until earnings are released.
At the current quotation, these shares stand to bounce back sharply in time. Still, given the cyclical nature of Cirrus’ operations, risk-tolerant accounts need only apply.
At the time of this article's writing, the author did not have positions in any of the companies mentioned.