Everybody loves a bargain, but finding a true bargain in the stock market can be a difficult task. When most people start the process of looking for undervalued stocks, the first thing they tend to look at is the price investors are currently paying for each dollar of the company's earnings, or the price to earnings ratio (P/E ratio). To come to the opinion that a stock is a bargain, the P/E ratio is normally compared to the market P/E, the industry P/E and different versions of its own P/E. In this review, we take a look at three types of P/E ratios: the trailing, forward and normalized P/E.
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The trailing and forward P/E is based on the trailing 12 months of earnings and the forecast of the next year's earnings, respectively. The interesting ratio here is the normalized P/E ratio in the fifth column of the table compiled below. As businesses go through the ups and downs of the economic cycle, so too do their earnings and valuation ratios. The normalized P/E smooths out the fluctuations (normalizes) by finding the average P/E ratio of the company over the cycle. There are variations of the ratio, but here we look at the average P/E ratio going back five years.
With that said, here are the top seven lowest P/E stocks in the S&P 500:
|Company||Ticker||Trailing P/E||Forward P/E||Normalized P/E|
|Constellation Energy Group, Inc.||CEG||1.72||10.91||11.6|
|NRG Energy, Inc.||NRG||6.65||19.44||24.34|
|Merck & Co, Inc.||MRK||6.60||9.05||22.14|
|The Travelers Companies, Inc.||TRV||8.35||9.20||9.88|
|Data retrieved April 23, 2010.|
One of the companies I especially like on this list is the giant health benefits company, WellPoint. Looking at the table, you can see WellPoint is currently trading at a significant discount to market valuations and its own historic valuations. The stock has nearly doubled from its low in March of 2009, but remains relatively undervalued compared to its normalized P/E of 13.42 over the last five years. WellPoint's forward P/E of 8.54 which is also well below the normalized P/E.
The main reason why WellPoint has been in the dumpster recently centers around the uncertainty of how the new healthcare reform legislation will impact its bottom line. The health reform package will mandate insurance coverage for an additional 32 million people who are currently uninsured and also introduce limits on underwriting margins for companies like WellPoint. Overall, there doesn't appear to be anything significant that stood out in the health care that would justify the current low valuations in WellPoint, the stock seems to have been caught up in the political firestorm surrounding the legislation.
For example, the infusion of 32 million newly insured people who couldn't afford insurance before or were rejected by insurance companies could be seen as a driver for increased costs. But for those that wouldn't be able to pay there will be significant federal subsidies that should alleviate some of those concerns. In addition, there will likely be some flexibility for companies to spread the cost of higher-risk people among the total people currently insured.
Also, as the company with the largest membership base at over 33.7 million, WellPoint already operates on a scale that will allow it to absorb additional members without significantly affecting its cost structure. This scale will also give WellPoint negotiating leverage over service providers that would help it to preserve its margins. All in all, even if the legislation negatively affects the company's bottom line, I believe it will likely be negligible.
If you're looking for bargains in the S&P 500, this list would be a good place to start - especially WellPoint Inc. A lot of stocks in the healthcare sector fell out of favor with investors during the process of healthcare reform, and these are specifically the type of areas investors should look to first when looking for undervalued stocks. (For related reading, take a look at America's Top Dividend-Paying Stocks.)
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