I do not look at P/E ratios for industry and in terms of historical ranges. To understand why, let’s walk through an example where you have two companies, one which typically sells at 8 – 12 times earnings and another which sells at 18 – 24 times earnings. Both grow dividends at 7% per year, and both yield 2.50%. We would also assume that earnings are relatively stable in both, there is an equal history of dividend growth, and both companies have some sort of durable competitive advantage.
Company A trades at the top end of its P/E valuation range (P/E of 12), while company B trades at the low end of its valuation range (P/E of 18). If I was just getting started investing, I would choose company A any time over company B. This is because I am getting more earnings yield for each dollar I invest. This also provides the company with certain options such as share buybacks to boost earnings per share. This could be more accretive to shareholders of company A than for those of company B. It doesn’t matter that the P/E is at the top of the range for company A, because I am getting more value for my dollars invested.
Of course if I already have exposure to company A, I would then start allocating funds to company B, which is the next best thing to put my money in. I will also do it because I like to be diversified and not keep all my eggs in one basket.
So as you can see, my method of screening provides a very good launching pad for evaluating opportunity cost, and selecting the most optimal investments at the time. It is superior to looking at past P/E ratios and industry P/E ratios, because it focuses on finding value today, relative to the rest of the market opportunities of the day.
To summarize, I use the P/E as one of the tools to narrow down list of prospects to a manageable level, and then help me to choose between dividend stocks. This low P/E, coupled with my qualitative and quantitative analysis of companies, helps me identify and purchase shares in the best bargains at the present moment. I have money to invest every month, so this P/E of 20 helps me avoid overvalued securities, and helps me to find the best bargains in the market at the time I have to allocate my capital.
Full Disclosure: Long CVX, XOM, WMT, MCD, PEP, JNJ, KMB & TGT