Historical studies have shown that purchasing shares with a low price-earnings ratio (P/E) has achieved better returns than if you'd purchased 'growth' shares with a high P/E.
Now, I must say, every super stock-picking strategy works – until it doesn't.
That's because investing is part art and not a science to which there is an exact answer or formula.
However, it makes sense to purchase a company's profits or 'earnings' (that is, the 'E' in the P/E ratio) for the lowest price (the 'P') possible.
As an aside, the P/E ratio tells us how many times of last years' profits/earnings we are paying if we bought shares at their current price. For example, if a company had profits/earnings per share of $1.00 and a share price of $20, its P/E is 20x (that is, 20/1 = 20).
Here're five big name ASX-listed companies currently boasting P/E ratios lower than markets, or S&P/ASX 200's (ASX: XJO) (index: ^AXJO) average of around 15x.
| Company | P/E Ratio | Dividend Yield |
| Australia and New Zealand Banking Group (ASX: ANZ) | 11x | 6.5% fully franked |
| Woolworths Limited (ASX: WOW) | 13x | 5.6% fully franked |
| G8 Education Ltd (ASX: GEM) | 14x | 6.6% fully franked |
| Flight Centre Travel Group Ltd (ASX: FLT) | 14x | 4.4% fully franked |
| Rio Tinto Limited (ASX: RIO) | 13x | 5.4% fully franked |
| Market (S&P/ASX 200) | 14.77x | 4.9% |
Data sourced from CMC Markets; note: the 'x' simple means 'times' (e.g. ANZ's P/E is 11 times)
Buy, hold or sell
In my opinion the biggest weakness of the P/E ratio – and dividend yield for that matter – is that it is a static measure of value.
For example, Rio Tinto is expected to report a more than 50% fall in profits in the coming year. This will have the impact of pushing down the 'E' in the P/E and, therefore, will result in a much higher P/E ratio than it is today.
So before making any investment decision it's imperative you look beyond the P/E ratio and dividend yield and have a thorough understanding of the business, and its growth outlook, before buying shares.
Of the companies above, I think Flight Centre is the only clear buying opportunity for long-term focused investors, but Woolworths is also very close to being investment worthy.
