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Stock Picking Using P/E Expansion and Contraction

Andrew is a self-educated business owner and entrepreneur with plenty of free advice (which is worth exactly what you pay for it!).

How can changing P/E values help you decide when to buy and sell?

How can changing P/E values help you decide when to buy and sell?

Why P/E?

Price multiples like the P/E ratio have long been used to analyze stocks, and the adage that it's generally better to buy a stock when it's selling at a much lower multiple of earnings might as well be a creed value investors tell themselves each morning.

After all, if you turn it on its head, the P/E (price-to-earnings) ratio describes what sort of earnings you can expect in the future, and this is exactly the way to value a stock: Take a guess at how much money the business will make in the future, and then discount those numbers back to what the money would be worth if you had it today (after all, a bird in the hand is worth . . .).

If a stock has a P/E of 10, then you're paying $10 for every dollar of earnings. Additionally, you want to be clear on whether you're looking at forward earnings estimates (used to calculate what's sometimes called a "forward P/E"), and this makes a difference. If you're using past earnings, you've got a precise number to work with as opposed to a guess at what the future looks like, but in a fast-changing company, the analyst's guesses might give you a much clearer picture of where a company is headed.

It's also a good idea to take a look at other price multiples and metrics, especially free cash flow as it pertains to price since free cash flow is what's leftover to pay investors. Throughout this piece, I'll discuss P/E expansion and contraction, but the principles contained herein will apply to FCF/E (Free Cash Flow to Earnings), Price to Sales, and plenty of other common Peter Lynch numbers.

The Steady State

When the market values a stock, it usually assigns a price multiple based on a comparison to the rest of the industry or sector where the stock resides. If you get a sense of where this number sits over time, you can notice immediately that the multiple goes through stretches of time where it's static—the steady state, or the "normal multiple." I hesitate to use the word "normal" here, but everyone else does, so we're sort of stuck talking around the idea that there's nothing "normal" about a number that sits still for a couple of years then moves somewhere else.

Other times, a stock might have little correlation to its industry in terms of P/E, especially if the company has unique characteristics (e.g., if it's a dominant player in the industry with a wide moat), so getting to know the individual stock is better than trying to understand industry multiples in isolation.

Take a look at how the company trades over time in order to understand this concept better. Check out the 20-year chart of Merck, the pharmaceutical giant, below; the blue line represents the "normal" multiple, or the P/E at which Merck normally trades, and the black line represents Merck's stock price over the same time frame:


The Power of Mean Reversion

The main thing to notice with this chart is that every time MRK's price goes far above or far below the multiple that the market assigns it, the stock tends to find its way to a price corresponding to the average P/E over time. One potential catalyst for realizing value much quicker can be a reversion to the mean, but trying to figure out exactly when this might happen is a sort of fool's errand.

Instead, I've tried to think of multiple expansions for undervalued stocks as a part of the margin of safety calculation. Using the MRK chart example above, if you bought when the stock was cheap and then sold when it was selling at a more normal multiple, you could have attained an extra 15% in return per year. A little extra "juice" from a stock that moves from a P/E of 10 to a P/E of 12 can give you an extra 20% on your return, but this sort of reversion isn't something you can count on happening . . . it's just sort of, well, nice when it does, and that's why it's better to think of this as a part of your margin of safety calculation—not intrinsic value.

On the flip side, you can invert your thinking and avoid potential pitfalls. Looking at the same chart, if you bought when the stock was expensive, you can see that you could have had a zero or even negative return for as long as eight years.

If you know me at all, you know I'm a huge fan of checklists and filters with the idea to subtract stocks quickly from the overwhelming universe. The idea is to quickly determine whether a stock is selling at a higher multiple than it normally does. If so, just steer clear for now, and remember that you don't have to swing at every pitch.

Just a Filter

At the end of the day, P/E contraction or expansion shouldn't be the only (or even the main) determining factor as to whether you buy or sell a stock, but it can certainly be an extra data point to consider. Use subtraction to disqualify any ultra-expensive stocks, and identify screaming potential bargains selling at unusually low multiples.

Consider using the screen for your current holdings too, especially if there has been a recent spike in price. If the price rise is accompanied by an increase in earnings, it might make sense to continue holding your stock, but by eyeballing the forward P/E ratio and seeing if it's staying consistent, you can get a really quick idea of whether a stock is moving away from its intrinsic value. If it is, it's probably time to sell.

This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.

© 2021 Andrew Smith