Increasing P/Es for Stocks on the Move

Studies show 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 four quarters equal $1 per share. Its P/E ratio will therefore be 20. ($20 divided by $1 = 20)

If the earnings rise to $1.25, for instance, but the stock doesn’t, then 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 its 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 earnings come out and its four-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 will 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.)

This increase in price and earnings is an ideal way to spot stocks in favor and that are anticipated to continue to trend higher. And 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 like 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.

When we first published this screen in January of 2003, the screen I was using was:

• Current P/E’s that are at least 20% higher than their P/E’s from three months ago (but not greater than 100% higher).

• And the stocks also had to be over $10 and have a minimum daily volume of 100,000 shares traded.

In follow-up articles, I added some additional parameters to the screen; most notably, filters to ensure that all of the stocks saw an increase in their earnings. (If prices are rising without an increase in earnings, there’s no real reason for prices to continue to rise.)

• So I wanted 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.

In this week’s screen, they’re all combined, which includes trading at $5 or higher three months ago with a minimum daily volume of at least 100,000 shares traded. (This screen by the way is available in the Research Wizard.)

Here are three stocks from this week’s list (4/4/06):

CLMS Calamos Asset Management, Inc.
SEAB Seabright Insurance Holdings, Inc.
VTS Veritas DGC, Inc.

I have found this to be an excellent screen to help 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 and find out how .

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.