Why do people like low PE stocks? Because low PE is an indicator of undervaluation. What is the significance of undervaluation? Such shares have the potential to yield better returns. Read about the basics of the P/E ratio here.

But relying only on ‘low PE’ for stock picking is not advisable. Because low PE of stock may also point towards bad fundamentals. Hence it’s essential to confirm the fundamentals of Low PE stocks before investing in them. So let’s dig deeper into the concept of Low PE stocks.

List of quality low PE stocks

How Low PE stocks yield better long-term Returns

Stock investing has two types of returns: (a) dividend income and (b) price appreciation.

Low PE & better dividend yield

A 5-year PE vs Dividend yield (DY) chart of a stock (NSE: TCS) is plotted in the chart shown above. The effect of every change in PE is visible in the dividend yield (DY).

• Mar’2018: when PE was at 10.63 level, DY was at 3.4%.
• Mar’2019: PE rose to 24.1, so the DY fell to 1.3%.
• Mar’2020: when PE fell to 21.2, DY rose to 5.5%.
• Mar2021: PE rose to 36.52 and DY fell to 0.9%.
• Mar’2022: PE fell slightly to 35.95 level, and DY rose moderately to 1%.

This example highlights that a fall in PE (Price to Earnings Ratio) makes a stock dearer and vice versa. Why? Because a fall in P/E is associated with either a fall in price or an increase in net profit (EPS). Price fall will increase the dividend yield. An increase in PAT also means more dividends in the hands of the shareholders.

Low PE & better price appreciation

A low PE stock, whose other business fundamentals are also strong, will see a faster price appreciation. How? Fundamentally strong companies will experience faster future growth in terms of sales, EPS, net worth, etc. These growth rates eventually reflect in the stock’s market price. In fact, the stock market loves to see a growing company. Such companies are rewarded more handsomely.

Example (HUL): The EPS of HUL rose from Rs.18/share to Rs.39.2/share from Mar’13 to June’22 at a growth rate of 7.7% per annum. In the same period, the share price of HUL rose from Rs.466 to Rs.2528 levels. It is a growth rate of 17.5% per annum.

A reasonable EPS growth rate of 7.7% is rewarded by the stock market with price growth of 17.5% per annum. There are many more such examples. The stock market loves to see the fundamentals grow over time.

We can identify such companies by looking at their long-term PE trend. PE of HUL grew from this to this in the last 10+ years. The PE of such stock increase with time, leading to superior long-term returns (price appreciation) for the shareholders.

The PE Formula

The significance of a low PE ratio of stocks can be better understood if we know the PE formula. There are two components of PE as described below:

1. Price: It can also be expressed as the market value of the company (Market capitalization) per unit share. A falling market cap may lead stocks to undervaluation. In our pursuit of higher returns, we must look for fundamentally strong stocks whose market cap (or price) is falling. How to estimate if a stock’s price is low or not?
2. EPS: EPS is an acronym for ‘Earning Per Share.’ EPS is made up of two stock metrics, net profit, and shares outstanding in the market. Which stock will have a higher EPS? One which is making more net profits. A company that makes more profit each passing year, will eventually have higher EPS. A growing EPS is an excellent indicator of strong business fundamentals. For a given market price, the higher will be the EPS, the lower will be the PE.

What PE number can be called ‘low’?

What should be the value of PE so that it can be called “low”? 15. Benjamin Graham wrote this in his book, The Intelligent Investor.

Current price should not be more than 15 times the average earnings of the past three years.

According to Benjamin Graham, the lower the PE, the better. He even proposed in his book a range of values for the PE ratio. According to him, the maximum a stock’s PE ratio should go is between 10-15. But it must also be remembered that Benjamin Graham’s book, The Intelligent Investor, was published way back in 1949. 

In those times, there was less participation from retail investors in the stock market. Today, a lot more people are investing in the stock market. So there is demand for stocks. Hence, experts think that the low PE limit of 10-15 is no longer valid. In today’s times, there must be a different yardstick for the quantification of low PE stocks. Nevertheless, we still fathom PE15 as our benchmark for undervalued stocks.

Suggested Reading: Intrinsic value calculation based on Ben Graham’s formula.

Are All High PE stocks Overvalued?

These days, for experts, all high PE stocks are overvalued. In fact, some investors especially favor investing in high pe stocks. Quality stocks of some industries remain consistently higher. Read about PE ratios of industries in India.

Let’s understand it with an example of Bajaj Finance:

• Current Price: Rs.7,289
• EPS-TTM: Rs.142.41
• PE: 51.18 (7289/142.41)

If we use Benjamin Graham’s rule of PE15, Bajaj Finance is inordinately expensive. So it means, expert investors must be selling this stock, right? Not so. In the last 3 months, Bajaj Finance remained bullish (even at PE51 levels).

What could be the reason for this optimism? Why investors are still buying this stock at PE51 levels? The reason is hidden in the business fundamentals (future growth prospects) of Bajaj Finance. 

Hence, to understand if a PE is low or not, we must see it in conjunction with its potential future growth rate. The future growth interpretation can be made by looking at past numbers. On average, Bajaj Finance as a company has grown at 20% per annum.

When a stock growth is able to grow its fundamentals at these growth rates, its PE multiples will trade at high levels (like Bajaj Finance).

PE and Growth Rate

Stocks that have the potential for fast future growth, trade at high PE multiples. Investors are ready to pay a premium for such stocks. The point is, that even at a high PE multiple, a higher growth rate number can make a stock undervalued. How to interpret PE with growth? It can be done using another ratio called the PEG ratio. Read more about what is PEG Ratio.

A stock whose estimated PEG is less than one (< 1) can be said to be undervalued. No matter how high is the P/E ratio, if its PEG is less than one, the stock can be said to be low priced.

How to find quality low PE stocks?

A stock whose PE is low immediately attracts our attention. But we’ve also seen that high PE stocks are not always overvalued. There is all kind of stocks available in the stock market. Some trade high PE and some at low PE multiples. It can be confusing to find quality stocks. Hence, we’ve written an algorithm for our The Stock’s Engine that filters quality low PE stocks from other stocks.

Allow me to give you a glimpse of how the algorithm works.

It works in three steps:

• Step#1 – Comparison with Industry PE: The stock’s Engine calculates every Industry’s PE using a financial algorithm. It then compared the company’s PE with that of its Industry’s PE. All companies whose PE is less than that of their respective industry is considered low PE company. Furthermore, the degree of undervaluation is also given a due weightage in the score.
• Step#2 – Absolute PE Ratio: The algorithm prefers a low PE number. Why? Consider a company whose net profit is Rs.100 Crore and an EPS of Rs10 per share. At a PE of 2, its share price will be Rs.20 per share. At a PE of 8, its share will become Rs.80 per share. It means, that the lower the PE, the less the price we’ve to pay to buy shares compared to the company’s net profits. Hence, the lower will be the PE, the stock engine’s algorithm will render a higher score.
• Step #3 – Adjusted PE Ratio: The algorithm does not use the reported PE of the company. A company whose “other income” is abnormally high will generally report a lower PE ratio. In such a case the algorithm will ignore the “other income” component to compute the PE.

• Step#4 – PEG Ratio: In this step, the algorithm calculates the past EPS growth rates of the stocks. Using these values it calculates the PEG ratios. The lower will be the PEG ratio, irrespective of its PE multiple, the Stock’s Engine renders a higher score.

The algorithm then churns out the GMR score for its stocks using the scores obtained in the above three steps.

Final Words…

One can use the PE ratio as a tool to value good stocks. One can calculate Price Earning Ratio (PE) easily by dividing the market price of a share by its EPS. Once we have the PE ratio of a stock, we can use it in a variety of ways to draw a final conclusion. 

• The market price of a stock will tell only how much a stock is valued by the market. It is just a speculative indicator of valuation.
• EPS tells us how much profit the company has generated per share. A combination of the market price of a stock, and its EPS gives us a PE ratio.
• Generally market overrates good stocks. One can use the PE ratio to roughly gauge if the stock is overvalued or undervalued. One of the easier ways to check the valuation of stocks is through parameters like intrinsic value, PE ratio, and PEG ratio.

The Stock’s Engine is also coded to estimate the intrinsic value of about 850+ stocks.

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