A common mistake investors make when evaluating if a share is a ‘Buy’

One of the most popular ways to check if a share is a buy or sell in the stock market is to take the price of the stock or a pool of stocks, and then divide that by earnings. This is called the price/earnings (PE) ratio. When the PE ratio is above some longer-term average, the stock is considered expensive – and possibly a sell. When it’s below average, it’s considered cheap – and possibly a buy.

That’s one of the easiest, and potentially costliest mistakes an investor can make…

While using the PE ratio above is useful, and often accurate – using it like this at face value is a mistake.

You see, there are several other things to consider. If you ignore them, you can miss out on great buy opportunity or make a bad choice and lose your investment.

#1: High PEs don’t always mean shares are expensive

If a company is in a growth phase with profits shooting through through the roof, a high PE isn’t necessarily bad – it could simply indicate expectations of investors.

You often find high PE/high growth type shares in the tech sector.

Let’s say for instance a share at R10, with earnings of 50cps – has a PE of 20. If this company grew profits by 50% in the coming year, earnings would grow to 75cps.

Suddenly the share would be on a PE 13.33. And now it looks MUCH cheaper than one year ago!

If you dismissed the share purely based on its CURRENT PE ratio you’d have lost out as its fast growth rate is another reason to invest in it…

• Negative PEs don’t mean a company is going bust

When a PE ratio is negative it means a company made a loss for that year – its earnings are negative.

But making a loss in one year doesn’t mean a company is in trouble or on its way to bankruptcy.

There are many reasons why a company’s earnings may be negative for the year…

For instance, it could be down because of a big acquisition or restructuring…Or it could have done impairments on the carrying value of assets…Or even the costs associated with staff retrenchment.

The key thing is most of these things will often mean improved profits in the future – but make the current (or past situation) look negative. Often, as in the case of impairments, the loss the company made is on PAPER and not even real money.

In this case, looking at the cash flow side of the business might show you that the company still increased its cash flow from sales and business activities – which is a very positive sign.

• Low PE’s don’t always mean cheap shares…

Right now, there are just over 103 shares on the JSE that have PE ratios between 0 and 10.

That’s 103 ‘Low PE’ shares. But does that mean all of these shares are undervalued and good buys?

Most certainly not…

In fact, there are several that are illiquid, others like mining stocks operate in extremely cyclical industries, which may be in a downturn right now.

By applying a filter that also includes only companies growing earnings by 25% or more, we arrive at only 41 shares.

So suddenly, more than 50% of the ‘undervalued’ shares are not even worth looking at!

You need to avoid the curse of history when looking at PE ratios

The major flaw in evaluating shares based on their PEs is the ratio is calculated based on historical earnings. Future earnings may differ significantly.

That’s why you need to look forward, as well as backward when considering a PE ratio – and not do it in isolation. Debt levels, liquidity and growth rates of a company and its sector all affect what the future PE ratio will tell you.