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The following article is based on a chapter from Aswath
Damodaran's book
Investment Fables.
What makes a cheap stock a
good value?
There are a multitude of things to look at when
determining whether a stock is cheap: the price, market cap,
earnings per share, or dividend yield. One commonly used
metric is the price to earnings ratio (P/E), which allows
investors to compare companies across a level playing
field.
Keeping it simple
While it is not the be-all-and-end-all metric, the
beauty behind the P/E ratio is its simplicity. Logic would
argue that a stock trading at a lower P/E than its peers
could be mispriced, and therefore a potential value. Finding
mispriced stocks is a fundamental principle of value
investing, and there is plenty of evidence that low-P/E
stocks outperform higher-P/E stocks over the long haul.
Another reason why low-P/E stocks can make attractive
investments is that they offer a nice alternative to bonds.
Although stocks do not have coupon payments like bonds do,
they do have an expected earnings yield. It is simply the net
earnings per share divided by the share price, or the inverse
of the P/E ratio. Therefore, stocks with low P/E ratios have
high earnings yields. As an example, a company that has a P/E
of 12 has an earnings yield of 1/12, or 8.3%.
Measuring value
Unlike a bond, though, the earnings yield is not
guaranteed. The only way for investors to cash in on earnings
is when companies pay them out through dividends. Below are
some low P/E stocks with their corresponding earnings and
dividend yields:
Company
CAPS Rating
(out of 5)
P/E*
Earnings
Yield
Dividend
Yield
Agrium (NYSE: AGU)
*****
9.4
10.6%
0.2%
Baker Hughes (NYSE: BHI)
*****
11.7
8.5%
1.4%
FairfaxFinancial (NYSE: FFH)
****
6.2
16.1%
2.3%
General Dynamics (NYSE: GD)
****
10.1
9.9%
2.4% Continued... |