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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 12-month earnings of $1.00, its P/E would be 20.  Each dollar of earnings is worth $20 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 $40.00 for each dollar of earnings. 

The price to earnings ratio is a valuation metric, helping to decipher if a stock is undervalued, fairly valued or overvalued.  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 concentrate 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 high P/E screen can also find some hidden gems.

A recent screen turned up fast growth companies like The Knot (KNOT) and Netflix (NFLX).  E*Trade Financial (ETFC) also turned up, which might interest aggressive value- oriented investors looking for a potential turnaround candidate.

The Knot

The Knot operates as a lifestage media company targeting couples planning their weddings. Its principal brand, The Knot, is a wedding resource, which reaches engaged couples through its Web site, TheKnot.com, and various other sources. The company owns a variety of other Web sites focusing on wedding gifts, the newlywed lifestage, and first-time parenthood. Officers and directors own 6.0% of the company’s outstanding shares.

The Knot reported a decent top-line advance in the second quarter (third-quarter earnings are due out tomorrow). This was due to healthy growth in national online advertising, which increased 10% from the prior-year period. Merchandise revenues advanced moderately, too. Registry revenue declined dramatically, due to the early termination of an agreement with Macy's (M). However, this was more than offset by increased publishing revenue, which resulted from the introduction of the first of two additional issues of The Knot wedding magazine. Nevertheless, cost of revenue and operating expenses also increased, and share earnings declined from the prior-year period. That said, we expect further strength in national online advertising and additional niche Web site launches to keep revenues and earnings on an uptrend over the next few years.

Netflix

Netflix is the largest online entertainment subscription service in the United States, with over 100,000 DVD titles for rental. Various subscriber plans allow users to rent up to eight movies at once, with no due dates or late fees. Monthly plans vary from $4.99 to $47.99. Nationwide centers allow most subscribers next day delivery. Many of the plans also come with the company’s streaming online video service. The company builds its DVD inventory via direct purchase and revenue sharing agreements with distributors.  Officers and directors own 22.3% of Netflix’ outstanding common stock.

Netflix’ shares reached all-time highs following the subscription movie provider's third-quarter earnings release.  The company reported revenue and share-earnings growth of about 31% and 35%, to $553.2 million and $0.70, respectively, year over year in the quarter. Moreover, the company increased its subscriber base from 15.0 million to 16.9 million. Subscriber acquisition costs declined, too. The increasing popularity of its online streaming offering has proven an important growth driver for the company.  Online streaming is likely to play an increasingly important role in the coming years. In addition, the recent introduction of this offering in Canada represents a foray into international markets.

E*Trade Financial 

E*TRADE Financial Corp., a family of companies, provides financial services through its branded web site, over the phone, and through financial centers. The company offers trading, investing, banking, and lending services to retail and institutional customers. Securities products and services are offered by E*Trade Securities LLC, a registered broker dealer. E*Trade Bank, member FDIC, offers banking and lending products and services. Officers and directors own about 10% of the company’s common stock.

The e-broker posted profits in the second and third quarters of this year, an impressive move into the black after 11 consecutive quarters of red ink. Third-quarter results illustrated management’s progress in turning E*TRADE around and positioning it for future growth.  Both the brokerage side of the business and the bank side appear to be performing better than they have in recent years.  Steven Freiberg, Chief Executive Officer of the company noted that “Our progress provides us the opportunity to invest in our customer franchise with a focus on initiatives and enhancements that we believe will increase customer satisfaction, drive revenue growth, and deliver shareholder value.”  Although these shares are clearly not for those with weak stomachs, the more adventuresome might be interested in investing in the company’s turnaround potential.


At the time of this article's writing, the author did not have positions in any of the companies mentioned.