Increasing P/Es for Stocks on the Move

Studies have shown that the best stocks over the past decade saw their P/E ratios increase by more than 100% from their breakout point. The good news is that you can use screening tools to catch these stocks early in their breakout cycle and ride them up for big gains.

Here's an example to explain this scenario. Say a stock price is at $20 and its earnings over the last 4 quarters = $1 per share. Then its P/E ratio will be 20. ($20 divided by $1 = 20)

If the earnings rise to $1.25 (for instance) and the stock doesn't, the P/E ratio will fall. ($20 divided by $1.25 = 16)

If Earnings go up but Prices don't, the P/E ratio will decrease. (But typically, as earnings increase, so should prices.)

If the stock rises and earnings stay the same, the P/E ratio will increase. If the stock is now at $30 and its earnings remain at $1, ... the P/E will have increased to 30 as well. ($30 divided by $1 = 30)

If Prices go up but Earnings don't, the P/E ratio will increase. (But this scenario is probably short-lived because the demand for a stock (prices) only goes up when earnings are going up, or at least expected to.)

But now let's say next quarter's earnings come out and its 4-quarter combined numbers show the EPS at $1.25, and the stock has also increased to $30. The P/E ratio will now be 24. ($30 divided by $1.25 = 24 -- a 20% increase in its P/E ratio from the first example.)

If Earnings go up, and Prices go up as well, the P/E ratio can also increase. (The interesting dynamic is that as earnings increase, so should prices. And as forecasts for continued earnings arrive, the demand for the stock should continue to send prices even higher. This type of scenario (higher earnings and higher prices) has longevity and is common in most trends.)

In short, increasing earnings creates demand. And investors are willing to pay more for earnings now because, as earnings increase, they believe these earnings will cost more in the future.

This increase in price and earnings is an ideal way to spot stocks in favor, and that are anticipated to continue to trend higher. Instead of looking for nominal P/E changes, screen for P/E increases in excess of 20%, which should provide the greatest upside potential.

Just as a 20% increase in the price of a stock can alert you to a new potential uptrend, you can also use a 20% increase in the P/E ratio to alert you to potentially significant price and earnings events.

The screen I’m running this week is:

• Current P/Es that are at least 20% higher than their P/Es from 3 months ago (but not greater than 100% higher).

• I want to see an increase in the most recently reported Quarterly Earnings (recent over last) and an increase in the Quarter's Earnings before that (last over previous).

• And for good measure, I wanted last year's EPS growth to be greater than the previous year, along with projections for this year's growth to be greater than last.

(If prices are rising without an increase in earnings, there's no real reason for prices to continue to rise.)

(This screen, by the way, is available in the Research Wizard and it's called sow_increasing_pe.)

Here are 5 stocks from this week's list (8/11/09) that look great:

ACL - Analyst Report Alcon, Inc.
CRMT - Snapshot Report America's Car-Mart, Inc.
FLR - Snapshot Report Fluor Corp.
MATK - Snapshot Report Martek Biosciences Corp.
TMK - Analyst Report Torchmark Corp.

I have found this to be an excellent screen in helping me find stocks that are on the move with expectations of continued improving fundamentals.

Use this screening strategy alone or with other criteria to help spot winning stocks BEFORE they become BIG winners!

Most screeners don't have historical P/E ratios (or other historical measures), but the Research Wizard stock picking and backtesting program does. Use it today, and see what new stocks you should be looking at.

Click here to learn more.

Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.

Disclosure: Performance information for Zacks’ portfolios and strategies are available at: http://www.zacks.com/performance.