I buy stocks mostly based on low PE ratio. Are there situations where a stock is a bad buy in spite of having a low PE? What's the next major stat I should look for before concluding?
Yes, there are situations where a stock is a bad buy in spite of a low PE.
PE ratio tells you the current share price divided by the prior 4 quarters earnings per share. It does not consider:
- sustainability of the business
- competitive threats
- management competence
- management integrity
- cash flow
- dozens of other things crucial to an investment decision
Imagine someone walked up to you and said, "Do you want to buy a piece of my business? I'll sell you 1% of it for $1000. Last year the business earned $25000." A quick calculation shows a PE of 4 [$1000/($25000 *.01)]. Even though this PE is comparatively low, you wouldn't buy in without a lot more info.
What kinds of things might you ask?
- What kind business is it?
- Who are your competitors?
- Who is leading the business?
- Can I trust the leaders?
- What assets does it have?
- What liabilities does it owe?
- What will the business look like in 10 years? 20?
PE is one tiny component of an informed investment decision.
PE can be misleading when theres a good risk the company simply goes out of business in a few years. For this reason some people use PEG, which incorporates growth into the equation.
Some companies have a steady, reliable, stream of earnings. In that case, a low P/E ratio is likely to indicate a good stock.
Other companies have a "feast or famine" pattern, great earnings one year, no earnings or losses the following year. In that case, it is misleading to use a P/E ratio for a good year, when earnings are high and the ratio is low. Instead, you have to figure out what the company's AVERAGE earnings may be for some years, and assign a P/E ratio to that.