When it comes to making investment decisions, limiting your potential for losses is arguably more important than hitting it big. While big gains are always a pleasure to see, a couple of large losses can decimate an entire portfolio and take years to recover from.
One of the best strategies individual investors can use to limit their potential for overly large losses in individual stocks is to limit their buying decisions to only those companies that are trading cheap relative to their earnings. In other words, make your picks from only those stocks trading at low P/E ratios.
IN PICTURES: 6 Millionaire Traits That You Can Adopt
The P/E ratio is widely used and simple to calculate. It represents the current market price for $1 of a company's earnings. Companies in the same industry generally trade at similar P/Es, so those trading significantly below their peers may be undervalued.
Stocks With Low P/E Ratios
Of course, a low P/E ratio doesn't tell the whole story. Some companies trading with low P/Es are justifiably cheap - they have serious problems that make them worse investments than their peers. But searching through low P/E stocks is a great starting point to find potential bargains worthy of follow-up research. With that in mind, let's look at five stocks currently carrying a low P/E price tag.
|Company||Trailing P/E||Market Cap|
|Amedisys (Nasdaq: AMED)||8.9||$1.3B|
|Endo Pharmaceuticals (Nasdaq: ENDP)||8.8||$2.5B|
|Denny\'s Corporation (Nasdaq: DENN)||6.6||$280M|
|Lexmark International (NYSE: LXK)||16.0||$2.9B|
|Safe Bulkers, Inc. (NYSE: SB)||2.9||$470M|
|Data as of June 10, 2010|
One of the likely candidates from this for follow-up research would be Lexmark, which develops, manufactures and supplies printing and imaging solutions globally. While Lexmark's trailing P/E of 16 may seem high in comparison to the other stocks on this shortlist, it is actually quite low when compared to industry rivals such as Canon (NYSE: CAJ) and Xerox (NYSE: XRX). Canon's trailing P/E currently sits at 26.9, while Xerox sports a 21.6 trailing P/E ratio.
While both Canon and Xerox are expected to grow their top-line sales by a greater percentage than Lexmark in the coming year, the difference is not drastic. Analysts currently expect Canon's total sales to increase by 8.1% and Xerox's by 6.7%, versus only an expected 1.3% increase for Lexmark. While this is a material difference, it alone does not justify the much more substantial difference in P/E valuations between these companies.
Denny's a Deal?
Another example of a possibly undervalued stock is Denny's, the company that owns and licenses the ubiquitous Denny's restaurants. With a trailing P/E of only 6.6, Denny's certainly looks cheap on the surface. But when compared to the 14 trailing P/E of Cracker Barrel Old Country Store (Nasdaq: CBRL) it looks even cheaper. Despite this substantial relative undervaluation, Denny's is expected to grow its full-year earnings per share by 27% over last year's numbers, while Cracker Barrel Old Country Store is only expected to see its year-over-year EPS increase by 12.%.
The Bottom Line
While a low P/E ratio does not tell the whole story, searching through low P/E stocks can be a great way to find undervalued bargains. Some stocks sporting low P/E ratios may very well turn out to be dogs, but if you consistently do your homework, you are likely to uncover some bargains as well. Averaged out across an entire portfolio, a basket of low P/E stocks has a good chance to outperform the overall market. (Learn more about P/E ratio, see: P/E Ratio: Introduction.)
Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!