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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 would not 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 1.00 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 Survey. For value-oriented investors, this list of low price-to-earnings ratio stocks is a great place to start looking for investment ideas.Screens are available every week in the Index section of The Value Line Investment Survey.

This week we highlight two companies of interest that could be potential value investments based on P/E, Goodyear Tire (GT) and Conn’s Inc. (CONN).

Goodyear Tire

Goodyear Tire, based in Akron, Ohio, manufactures tires for automobiles, commercial trucks, light trucks, SUVs, race cars, airplanes, farm equipment and heavy earth-mover machinery. It is one of the world’s largest tire manufacturers, with brands such as Goodyear, Dunlop, and Kelly. With a strong reputation, Goodyear has managed to maintain its position within the tire industry.

While the company has struggled since the recession, management has done a solid job of improving profitability over time by revamping its cost structure. Goodyear reported a 43% year-over-year increase in its bottom line in 2013, with share net at $2.62. Through the first half of 2014, the company has improved earnings over the previous year's figures with rising volumes in its core North American business. Goodyear also continues to regain market share it had previously lost.

We remain upbeat about the near-term forecast, however, there has been some uncertainty regarding Goodyear’s unfavorable product mix shift toward cheaper parts and away from its lucrative commercial goods. However, profit margins should continue to widen at a gradual pace, and volumes ought to remain steady as management places greater emphasis on value-added products that are less vulnerable to price competition. Moreover, Goodyear plans to build a new facility in the Americas that will manufacture value-added tires for consumers. This new plant should be operational within the next three years, and could provide greater earnings potential in the long run. The 2014 earnings tally should rise nicely over the 2013 figure, with continued growth expected in 2015, as well. Investors should acknowledge these growth opportunities, including an improving earnings forecast, and consider the current price as a bargain at this time.

Conn’s Inc.

Conn’s Inc. is an electronics and appliance retailer headquartered in The Woodlands, Texas. The chain retailer operates about 79 retail stores in the states of Texas, Louisiana, New Mexico, Arizona, and Oklahoma. Additionally, the company provides proprietary credit solutions for consumers. Other product offerings include home appliances, furniture and mattresses, consumer electronics, and home office equipment.

The company’s stock has been surging in price over the past few years, after a disappointing performance in 2011. Full-year fiscal earnings have grown consecutively since then, with 2013 share net coming in at $2.54, a 62% increase over the 2012 figure.

However, the stock experienced a sell-off in the July quarter as earnings per share fell short of consensus. The problem appears to be with delinquent payments. Indeed, the Credit segment's operating income declined $7.7 million to an operating loss of $0.2 million, as the percentage of customers with balances that have been delinquent for over 60 days rose 70 basis points. The impact of a higher expected provision for bad debts, and some additional interest expense from new debt issuance, prompted management to lower its full-year fiscal 2015 guidance from the range of $3.40 to $3.70 per share to the range of $2.80 to $3.00 per share. On the bright side, same-store sales rose 11.7%.

Conn’s continues to expand its store numbers, with two new openings in Colorado this past summer, and two in Tennessee. With its expanding footprint, we expect the company to continue to deliver greater revenues which should trickle down to the bottom line as long as it maintains a healthy operating structure. Additionally, sequential improvement to its credit segment augurs well for long-term gains.

The forecast remains decent for Conn’s, particularly on the bottom line, where we project a solid year-over-year gain for fiscal-2014 earnings, and continued momentum for 2015. Although shares have dropped almost 45% in price since January 2014, the company has managed to readjust its focus and deliver results. That said, due to the volatile nature of this industry, these shares remain on the risky side, despite having favorable long-term appeal.

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