Among the multitudes of financial ratios investors use, the price-to-earnings (PE) ratio is one of the most indispensable metrics for stock analysis. The PE ratio offers a quick yet meaningful glimpse into the relationship between a company’s share price and its underlying profitability. It allows an apples-to-apples comparison of stocks within the same sector to determine which companies trade at relatively high or low valuations compared to their earnings.
A high PE ratio usually indicates that investors expect superior growth from the company and are willing to pay a premium for its shares. On the contrary, a low PE ratio could signal an undervalued or attractive buying opportunity if the business fundamentals remain strong. Read on to understand the PE ratio and know the top companies with low PE ratio stocks.
The price-to-earnings ratio, or PE ratio as it is more commonly known, is an invaluable metric that compares a company’s current share price to its earnings per share. It offers crucial insights into investor perceptions of valuation.
In simple terms, the PE ratio reveals how much an investor is willing to pay for every rupee of earnings that the business generates. It is calculated by dividing the current stock price by the company’s earnings per share.
By comparing PE ratios across industry peers, you can gauge whether a particular stock is richly or cheaply valued relative to similar firms. As a general rule of thumb in stock market investing:
PE ratios lower than 15x signify potential undervaluation.
PE ratios exceeding 20x signal possible overvaluation.
Low PE ratio stocks refer to stocks that trade at price-to-earnings valuations below the overall stock market average or their sector peers. A stock with a PE ratio lower than 15x is generally considered a low PE ratio. These stocks appear undervalued by the market relative to their earnings capability.
Low PE ratio stocks tend to fly under the radar but can be potential multi-baggers if their growth and fundamentals hold up over time. However, some low PE ratio stocks may be cheap for a reason, so prudent analysis beyond just valuations is necessary. Comparing low PE stocks within industries allows for finding relatively undervalued opportunities worth further research.
Low PE stocks hold specific inherent merits, making them rewarding additions for discerning investors seeking undervalued opportunities. The following are some of the significant advantages:
A low PE ratio indicates investor apathy or neglect, making the stock relatively undervalued and underpriced vis-à-vis its earnings capability. This presents lucrative value-buying opportunities for astute investors who recognise this disconnect.
As the company delivers on profitability expectations over time while maintaining growth, the market is bound to take cognisance sooner rather than later, leading to stock price appreciation.
An offbeat facet of low PE stocks is their very reasonable value, whose actions provide ample headroom for strong price surges once business fundamentals hold steady. Fund managers hunting for earnings consistency at bargain valuations are bound to make a beeline for such stocks.
Low PE shares’ relatively reasonable purchase price is an inherent downside cushion during market declines. Think of it as a margin of safety that offers the first level of capital protection in case industry external shocks negatively impact earnings visibility.
An added allure of undervalued low PE stocks is that they offer higher-than-average dividend yields, creating regular income streams for investors. Strong cash flows allow these firms to distribute steady dividends from profits regularly.
As capital gains accrue through price increases in line with earnings growth, the regular dividends further sweeten investor returns.
During high inflation environments, when input costs surge while consumer demand slackens, low PE stocks act as effective hedges to beat inflation blues. Their earnings streams and stock prices gradually align with inflation over time.
Thus, they perform better than high-growth, high-momentum stocks vulnerable to demand destruction during inflation.
Identifying golden opportunities among low PE stocks requires going beyond superficial screens to unearth the gems trade at a discount to intrinsic value. Following are some of the proven strategies:
Leverage stock screening tools available online and on brokerage platforms to filter specifically for low PE ratio stocks. However, resist the temptation to pick stocks randomly based on a low PE ratio.
The objective of screening is not to obtain the “lowest” PE stock. Instead, it is the starting point to discover good businesses trading at modest valuations relative to historical levels or industry benchmarks.
Once we have a basket of low PE candidates, we compare their PE ratios with industry peers to determine which companies offer better risk-reward propositions.
For instance, a real estate company trading at 8x PE signals a higher margin of safety versus another firm at 12x PE, assuming business fundamentals match. Relative undervaluation matters more than absolute low PE levels devoid of context.
Analyse the last three years’ financial statements focusing on parameters like sales growth consistency, operating margins, return on equity, working capital cycles, leverage position and cash conversion efficiencies.
The essence lies in distinguishing between low PE stocks with transient challenges versus those plagued by deeper malaise in financial performance.
Review profitability track record, especially during periods of economic adversity. Check for earnings manipulations or losses glossed over through accounting jugglery using extraordinary income items.
The objective is to assess actual, high-quality, sustainable core earnings capabilities that allow the firm to deliver across business cycles.
Examine factors driving future earnings growth trajectories beyond current financials. Assess aspects like new product pipelines, expansion plans into new territories, and scope for operational improvements through technologies like automation. Valuations expand in tandem with clarity on forward earnings.
While predominantly a quantitative screening approach, incorporating qualitative perspectives allows for developing more profound convictions. Analyse parameters like capable management and the longevity of competitive advantages from brand equity, patents, proprietary technologies, and distribution muscle. These intangible yet durable moats provide vital clues to business resilience.
Determining a stock’s price-to-earnings (PE) ratio is crucial to assessing whether it trades at a premium or discounts its profitability.
The math behind computing this valuation metric is pretty straightforward, though it requires gathering a few data points from the company’s financial statements. The following is the step-by-step process that you can use to calculate the PE ratio:
The first input required is the current stock price in the equity markets. This is readily available from stock market data sources—just look up the scrip’s latest market price or closing price. For instance, if XYZ Ltd closed at Rs. 60 in the latest trading session, we take this as the market price.
Next, you must determine the company’s EPS over the trailing 12-month period. EPS indicates how much profit the company has generated for each share outstanding. This critical number can be obtained from the firm’s latest quarterly or annual financial results reports. Assume XYZ Ltd’s EPS over the last year is Rs. 6.
Divide the current market stock price by the EPS figure to arrive at the PE multiple. In our example, it is:
PE Ratio = Market Price / EPS
= Rs. 60 / Rs. 6
PE Ratio = 10x
So, XYZ Ltd is currently trading at a PE ratio of 10x.
Next, compare this PE of 10x against the industry average to determine whether XYZ’s valuation looks relatively expensive or cheap. Assume the industry average PE is 14x. Since XYZ’s PE is below the industry benchmark, you can consider it a low PE stock.
Finally, you can evaluate the stock’s historical PE range over the last 5-10 years to identify any meaningful variance. This lets you determine whether the current PE reflects an outlier event or aligns with long-term valuation trends.
Identifying low PE gems with the potential for a substantial upside requires going beyond superficial screens to analyse the underlying fundamentals. Some typical hallmarks of attractively valued low PE stocks include:
Low PE stocks that consistently showcase new product development and innovation catering to evolving customer preferences signal future solid revenue streams. For instance, consumer goods companies foray into organic/natural variants to capture shifting preferences. The intent is to assess if low valuations are temporary and if earnings growth runways seem visible.
Analyse whether operating margins and return on capital employed have consistently expanded over the past 3-5 years. This indicates that the company is benefiting from scale efficiencies in procurement, production, distribution, or the phasing out of legacy costs. Margin expansion is a crucial driver of EPS and valuation growth—both factors are currently underestimated for low PE stocks.
Observe if the company has a track record of generating higher ROIIC relative to the cost of capital. This underscores management’s capital allocation proficiency to drive value creation – deploying funds only in projects surpassing hurdle rates. Market underappreciation and judicious re-investment at high IRR make for a value multiplier.
Examine the debt levels on the balance sheet and trends in cash flow generation from operations and free cash flows post-capex. Robust cash generation and deleveraging allow self-funding growth rather than equity dilution, enhancing shareholder returns. Markets tend to recognise such consistent deleveraging prowess eventually.
Analyse revenue growth consistency over the last 5-7 years relative to industry averages. Top-line expansion ahead of the broader sector signals substantial market share gains. This aspect is vital for markets to reconsider earnings growth potential for low PE stocks trading at seemingly attractive valuations.
Assess qualitative aspects like brands, patents, proprietary technologies, distribution muscle and integrated business models, creating durable competitive edges that are tough for newer players to replicate. The longevity and business resilience created by such intangible moats are critical to sustaining profitability and multiple expansions despite disruptions.
An experienced management team with demonstrated execution capabilities and commitment to rewarding shareholders through dividends/buybacks while maintaining high governance standards is a crucial lead indicator to assess business continuity and earnings consistency for low PE stocks.
While low PE stocks appeal to investors because of their seemingly attractive valuations, investors must recognise that such stocks also carry higher inherent risks that warrant careful evaluation. Following are some risks associated with Low PE Ratio:
Stocks trading at deficient PE levels could signal possible financial challenges or earnings uncertainty that has made investors risk-averse. Aspects that must be probed include outstanding litigation issues, history of losses, high debt obligations, working capital mismanagement, inventory pile-ups, receivables stretch and poor utilisation of fixed assets. While low PE multiples may appear tempting, avoiding value traps is critical.
Often, investors assume mean reversion, i.e. low PE multiples tend to revert to industry averages over time. However, some stocks fail to realise upside potential and continue languishing at lower valuations for long durations, thus becoming value traps. Changing industry dynamics, disruption by nimbler competitors, product obsolescence or mediocre management execution could imply that the business fundamentals do not support the modest current valuation.
By their very nature, low PE stocks tend to witness higher share price volatility as market sentiments swing. As earnings deliveries fall short of expectations or management commentary indicates near-term headwinds, investors are quick to penalise these stocks.
However, a small positive surprise on profitability or guidance can propel outsized price jumps owing to the low base effect. This unpredictability in share price movements can make low PE stocks challenging for investors with average risk appetite.
Given the higher risks, it becomes essential for investors considering low PE opportunities to delve deeper and discern the plausible reasons behind the market’s lukewarm response towards the stock. Various aspects that warrant a detailed investigation are:
Capital Allocation Strategies: Check where the company deploys profits and free cash flows. Disciplined companies with shrewd capital allocation focused on driving profitable volume growth or asset sweating tend to get re-rated sooner.
Future Growth Trajectories: Assess forward-looking statements, planned capex, product pipelines and addressable market size to determine earnings growth potential. Upside triggers are essential to valuations upside.
Market Position: Analyze factors like market share trends, competitive strengths on costs or distribution reach, customer stickiness and brand equity that determine the sustainability of market leadership and upside potential.
Management Execution Skills: Evaluate aspects like leadership bench strengths across functions, prior track record in crisis management, productivity enhancement drives, success with turnaround strategies, and capability to drive innovation. Superior execution skills become re-rating catalysts.
Entry Barriers: Determine the ease of competitor entry and associated risks. Deep competitive moats created from scale, proprietary technology or branding deter disruption threats that may limit earnings growth.
While identifying attractive, undervalued stocks is crucial, effectively incorporating low PE opportunities within one’s equity portfolio requires prudence, given the associated volatility. Here are five portfolio management strategies worth considering:
Blending low PE value stocks and higher growth-oriented shares can allow investors to benefit from stability and upside potential. Value stocks provide a cushion during market declines, while growth names drive alpha expansion in bull runs.
However, assess individual risk appetites—a 60:40 or 70:30 allocation between value and growth works well. This blended approach also ensures the avoidance of value traps.
Rather than simultaneously investing a lump sum capital into undervalued low PE stocks, considering averaging positions systematically over time can enhance risk-adjusted returns.
This entails steadily deploying small amounts into a stock at regular intervals—monthly or quarterly. The key is to build exposure at different price points. Benefits include mitigating timing risks and capitalising on intermittent dips to lower costs.
Value stocks often distribute steady dividend streams that can be used to compound holdings in the stock over long periods using the power of reinvestment. Opting for dividend re-investment plans allows dividend payouts to be channelled directly into buying more stock units rather than cash payouts.
Given the volatility risks, limiting the overall allocation to a low PE category within the equity portfolio bucket is vital. Restricting low PE exposure to around 30% of total equity allocation as a starting point allows reasonable room for upside while containing the drawdown risks. Further, one can assign individual stock-specific limits within the 30% bucket based on risk scoring.
Defining longer holding timeframes when investing in low PE stocks is crucial to allow the value creation story to unfold while providing room for volatility. As a rule of thumb, staying invested for over three years allows the business fundamentals, growth drivers, and underlying earnings potential to catch up. The key is to ignore interim price fluctuations triggered by quarterly misses/hits and stay focused on the long-term business trajectory.
Conclusion
While a low PE ratio serves as a helpful starting point for identifying potentially undervalued stocks, it would be imprudent to view it in isolation. Careful diagnosis of the reasons behind the seemingly attractive valuations, financial and qualitative fundamentals analysis, growth prospects and risks are crucial to determining investment merit.
By adopting a holistic research approach complemented by prudent portfolio strategies focused on long-term value actualisation, investors can tap into the alluring world of low PE investing to unlock hidden gems. The key remains to stay rational amidst inherent volatility while allowing one’s core investment thesis to play out over adequate time horizons.
A stock with a PE ratio lower than the industry average or below 15x is generally considered a low PE ratio. This signal that the stock may be undervalued or overlooked compared to peers.
Some reasons for low PE ratios include a poor near-term earnings outlook, investor disinterest or neglect, the superiority of future earnings potential not fully priced in by the market, and broader industry challenges temporarily impeding growth plans.
Key benefits are undervalued prices, attractive valuations for value investors, potential for upside as the market recognises earnings potential, low downside risks, and, in some cases, high dividend yields.
Key risks are financial problems dragging valuations, higher volatility in stock prices, value traps that fail to realise upside potential for long periods, and inherent business models or industry issues limiting earnings growth potential.
Neither high nor low PE ratios are inherently good or bad. Investors must analyse factors like future growth rates, consistency in financial metrics, competitive strengths and management pedigree to determine if valuations seem justified relative to intrinsic business potential.
Related Tags
Invest wise with Expert advice
IIFL Customer Care Number
(Gold/NCD/NBFC/Insurance/NPS)
1860-267-3000 / 7039-050-000
IIFL Capital Services Support WhatsApp Number
+91 9892691696
Download The App Now
Follow us on
2025, IIFL Capital Services Ltd. All Rights Reserved
IIFL Securities Limited - Stock Broker SEBI Regn. No: INZ000164132, PMS SEBI Regn. No: INP000002213,IA SEBI Regn. No: INA000000623, SEBI RA Regn. No: INH000000248
ARN NO : 47791 (AMFI Registered Mutual Fund Distributor)
This Certificate Demonstrates That IIFL As An Organization Has Defined And Put In Place Best-Practice Information Security Processes.
