Despite its simplicity, the P/E ratio is one of the most commonly used valuation tools in the market today. The ratio gives investors an easy and quick way to compare how much people are currently paying for every dollar of a company's earnings. (For a primer on this ratio, see our P/E Ratio Tutorial.)
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The most appropriate way to use the P/E ratio is to compare a company's P/E ratio to the average P/E of all the companies that make up the industry or sector the company is in. Companies that trade at a low P/E ratio to the industry may be relatively undervalued. In addition, the ratio should be compared to the average P/E of the company itself going back a few years, such as a five-year average P/E. As long as there hasn't been any fundamental shift in the business, this is a good way to support the analysis.
With that said, let's take a look at some large cap stocks that have relatively low P/E's and may provide an opportunity going into 2011.
|Lockheed Martin Corp||NYSE:LMT||9.8|
|Honda Motor Co.||NYSE:HMC||9.7|
|Eli Lilly Compay||NYSE:LLY||8.1|
This stock appears to be one of the more interesting companies on this list for a few reasons. First, the company pays a great 4.4% dividend yield, which is quite high considering the extremely low interest rate environment, and yields on comparable stocks. The quality of the dividend is also quite good, illustrated by its consistent rise from $0.44 in 2000 to $2.34 in 2009 and low payout ratio of 30%.
Second, in terms of valuation, the stock is trading at the lowest price-to-earnings multiple it has had over the past 10 years, currently at 9.8 versus the industry average of 12. Also, the fiver-year average P/E for Lockheed is approximately 13.3, suggesting there is quite a bit of room for the stock to move. Lastly, the increasing tensions between North and South Korea, although unfortunate, can serve as a catalyst for defense contractors over the medium term. Currently, Lockheed trades at just under $70, but this would be a good stock to keep an eye on in the next year.
The Bottom Line
The P/E ratio should not be used as the only tool to base an investment decision on. Sometimes a low P/E may be justified simply due to the deterioration of the business and expected low earnings going forward. However, as a starting point, the P/E is one of the quickest and easiest ways to spot a potential bargain.
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