How to Uncover Cheap Stocks Cont'd

July 23, 2006

In some cases, a high growth rate can compensate for an otherwise overvalued P/E ratio. A prime example is Google (GOOG), as most investors are anticipating greater growth than its peers. By placing such a bet, investors are in effect gambling that after a few years, the company’s P/E ratio will become in line with the industry. Google is currently trading at a multiple of 57.2 and continues to show that it can surpass analyst earnings estimates.

Investors should also be on the lookout for special one-time items that may distort P/E ratios. In May, Google sold its stake in Baidu.com (BIDU), resulting in about $63 million of additional revenue, inflating its P/E unnaturally. These one-time gains are usually irreproducible, and just give a false impression of strong past performance. Tax benefits and lawsuit settlements also contribute to these temporary anomalies.

Companies have the ability to decrease their P/E’s by posting strong earnings, and also buying back their stock with cash from their coffers. Microsoft (MSFT) announced last Thursday that it would buy back up to $20 billion of its own stock over the next five years in an effort to bolster shareholder value. These buybacks, along with dividends, are ways for companies to return equity to their shareholders.

ExxonMobil (XOM) is trading at a P/E of just 10.9, but it also holds the title of largest corporation by market capitalization. Its massive $387 billion market cap raises the question of whether it can continue to appreciate in value. It already surpasses the value of many small countries and produces greater earnings than their GDP’s. While a smaller oil stock like Valero (VLO) has appreciated 600% in the past 5 years, ExxonMobil has only seen 50% upside in the same period.

The smaller companies within a sector have the greatest potential to gain value, unless the industry doesn’t have any established players yet. The small cap Russell 2000 index has gained 59.3% since May 1999, while the larger S&P 500 is down 3.9%. Smaller companies with faster growth rates and the ability to bridge the gap in market cap often outperform their larger blue chip counterparts. Investors should be aware that these smaller stocks will also be susceptible to wild price swings. Risk-averse investors should stick with established, slow-moving stocks, while normal investors should take some risks.

Looking at P/E ratios and market caps collectively can be an effective method to generate superior returns. The average return for stocks historically is about 8-12% annually. By digging through the deluge of already-priced-in stocks and finding low P/E ratios, fast growth rate, and a relatively small market cap simultaneously, you will be able to consistently beat the market with stocks that head for the sky.


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At the time of publication, Dhinesh Ganapathiappan did not own or control shares of any companies mentioned in this article.