Here’s a small-cap investing expert on how to use the P/E ratio when evaluating companies

In investment circles, the price/earnings (PE) ratio is a well-known indicator used to assess whether a stock is good value or not.

A quick refresher; the ratio is calculated as the stock price (P), divided by company earnings per share (E).

As a general rule, if a company’s stock price is low compared to its underlying earnings, it may start to look undervalued (and vice versa).

In view of that, we asked the Stockhead number-crunchers to run some data on which ASX small caps have the lowest PE.

Firstly though, a quick word of warning when using the PE ratio as an investment metric; the ‘P’ is simple but the ‘E’, not so much.

For starters, it typically requires an estimate of a company’s future earnings over the next 12 months — a more subjective process that’s subject to change, unlike the current price which is just based on simple hard data.

Expert view

To get an understanding of how professional investors use the PE ratio to make decisions, Stockhead spoke with Dean Fergie, director and portfolio manager at Cyan Investment Management.

Fergie said he keeps on eye on various PE metrics to monitor trends, but it doesn’t form a core part of the company’s investment thesis.

“What we’ve seen over the last five or 10 years is the whole curve kind of get extended,” he said. “So on that basis, stocks with a low PE look cheap while high-growth stocks are looking really expensive.”

In other words, it’s more common for markets to get excited about the growth prospects for given companies, which sees their share price race well ahead of underlying earnings forecasts. That in turn lifts the PE ratio to much higher levels.

He attributed that shift mainly to two factors; an extended period of lower interest rates, and an influx of high-growth tech stocks with very scalable software businesses.

“For me, it can be a useful indicator for stocks with growth potential. For example, a fintech that’s scaling up is likely to have a higher PE than a bank,” Fergie said.

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However, he added that the PE in isolation is too simplified to be used as a sole guide for investment decisions.

“Anyone can do a simple rating based on the PE, but just because it looks cheap doesn’t mean it should be more expensive. So we won’t make any investment decision just base on the PE alone,” he said.

“People want to be able to simplify; distill things down to simple facts and come up with a solution. But the reality is it’s just not that easy.”

“It reminds me of an old investing maxim: Good stocks usually aren’t cheap; and cheap stocks usually aren’t good!”

Back to the data

American economist Robert Shiller devised an alternative version of the P/E ratio which takes into account earnings variables over a period of 10 years.

According to Shiller’s metric — which is usually applied to the broader S&P500 as a whole — a ratio of more than 20 indicates the market is overvalued, while a reading of less than 10 suggests that opposite.

Closer to home, the Stockhead data squad calculated the broader PE ratio for listed ASX small caps with a market capitalisation below $500m, resulting in a number of 26.38.

To filter the data for stocks which may look undervalued, they only selected stocks with a PE below 7 — around four times below the market average.

A total of 47 companies made the cut, across a relatively diverse list 17 sub-sectors. We split the categories between resources and energy, and the rest.

By definition, companies on the list need to have reported at least some profits; it excludes those that are loss-making.

Here are the 17 resources & energy stocks with the lowest PE ratios:

Importantly, the data is based on historical earnings numbers derived from each company’s most recent reporting period; not an estimate of future earnings.

In addition, Fergie noted that “often you need to look at P/E ratios pretty carefully. For example if a company is only just become profitable the ‘E’ (earnings) will be pretty low.”

Here are the other 28 companies on the list with historical P/E ratios of 7 or lower: