With the relative frothiness we've seen in the market over the last few months, it seems like every stock is making good money for investors these days.

But it's a simple fact that good ol' P/E ratios still matter.

Sure, I realize that some companies including Google (GOOG) continue to fare quite well in spite of their lofty P/E ratios.

But a closer look reveals that low P/E stocks continue to outperform higher P/E stocks.

As evidence, take a look at what's happened at a little company you might have heard of called Apple Computer (AAPL). In late January 2006 its stock was selling in the mid $70s and it sported a P/E ratio of more than 40 times trailing earnings. Pretty hefty!

Of course, some would argue that Apple's P/E at the time was justified, given that it wound up reporting a 46% year-over year earnings improvement in 2006.

However, a funny thing happened. In spite of its operational prowess and the fact that Apple delivered on the earnings front, its stock rose only about 11% during that same time.

Compare that to another well-known computer marker such as IBM (IBM). In late January 2006 it's stock was trading just north of $80 a share, and the company was trading at about 16 times trailing earnings.

During 2006, IBM reported earnings growth of 25%, which while impressive was well short of Apple's performance. So what happened to its stock? It's up just over 20% from a year ago, just about double Apple's percentage gain.

Is there anything special about IBM? Not particularly. It's had its share of ups and downs over the past year just as Apple has.

So what gives?

History suggests that over the last hundred years investors have, on average, paid about 14 times earnings for stocks they own. And while those same investors at times have deviated from this historical average, history also suggests that when P/E ratios become overextended, that the underlying stock (or index) will tend to suffer a period of underperformance as it trends back toward the mean.

In addition, when two like companies are compared side by side, everything else being equal, the company with the lower P/E will tend to outperform the company with the higher P/E. (For more depth on the nuts and bolts of the P/E ratio, check out Understanding The P/E Ratio.)

Need some additional evidence of the P/E to price relationship?

Check out the Johnson & Johnson (JNJ) vs. Merck (MRK) comparison. In late January 2006 Johnson & Johnson was trading just north of $56 a share and at a reasonable 16.52 times its trailing twelve month's (TTM) earnings. In 2006, it posted 11% year-over-year earnings growth. Not too shabby.

Meanwhile, in late January 2006, Merck was trading just above $33 a share, and at roughly 13 times trailing earnings -- a bit cheaper. How about it's earnings? In 2006, earnings were essentially flat from 2005 (however, given recent patent expirations those results were actually considered quite good).

What happened to the stock prices?

Johnson & Johnson's share price rose about 19%. Merck's rose about 33%.

Next, check out the McDonald's (MCD) vs. Yum! Brands (YUM) comparison. In late January 2006 McDonald's was trading at just over $34 a share, and at roughly 16.6 times trailing earnings. In 2006, it grew its earnings 39% over 2005's results.

Meanwhile Yum brands was trading just under $49 a share, and at 18.3 times trailing earnings. In 2006 it's expected to show a roughly 9% year-over-year earnings growth (its 2006 numbers haven't been released yet).

How have the stock prices fared?

Yum increased about 22%. McDonald's rose about 29%.

And you guys thought that P/Es went out of style when the internet revolution took hold. Ha!

The Bottom Line
Some will invariably argue that we are in a new era and that P/E ratios as a means of evaluation are simply a thing of the past. But given what I'm seeing, I would argue that they are as relevant as ever. Focus on the low P/E stocks and you've got a better shot at bagging market-beating returns.

Related Articles
  1. Mutual Funds & ETFs

    What Exactly Are Arbitrage Mutual Funds?

    Learn about arbitrage funds and how this type of investment generates profits by taking advantage of price differentials between the cash and futures markets.
  2. Investing News

    Ferrari’s IPO: Ready to Roll or Poor Timing?

    Will Ferrari's shares move fast off the line only to sputter later?
  3. Stock Analysis

    5 Cheap Dividend Stocks for a Bear Market

    Here are five stocks that pay safe dividends and should be at least somewhat resilient to a bear market.
  4. Investing

    How to Win More by Losing Less in Today’s Markets

    The further you fall, the harder it is to climb back up. It’s a universal truth that is painfully apparent in the investing world.
  5. Fundamental Analysis

    Use Options Data To Predict Stock Market Direction

    Options market trading data can provide important insights about the direction of stocks and the overall market. Here’s how to track it.
  6. Stock Analysis

    2 Oil Stocks to Buy Right Now (PSX,TSO)

    Can these two oil stocks buck the trend?
  7. Investing News

    What Alcoa’s (AA) Breakup Means for Investors

    Alcoa plans to split into two companies. Is this a bullish catalyst for investors?
  8. Stock Analysis

    Top 3 Stocks for the Coming Holiday Season

    If you want to buck the bear market trend by going long on consumer stocks, these three might be your best bets.
  9. Investing News

    Could a Rate Hike Send Stocks Higher?

    A rate hike would certainly alter the investment scene, but would it be for the better or worse?
  10. Investing News

    Corporate Bonds or Stocks: Which is Better Now?

    With market volatility high, you may think it is time to run for corporate bonds instead of stocks. Before you do take a deeper look into which is better.
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  4. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  5. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  6. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>

You May Also Like

Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!