Trying hands at bargain stocks that have a low price-to-earnings (P/E) ratio is a common practice. The perception is that the lower the P/E, the higher will be the value of the stock. This inference is drawn on the simple logic that a stock’s current market price does not justify (is not equivalent to) its higher earnings and therefore the stock has room to run.
But have you ever given it a thought that stocks with a rising P/E can also be worth buying. We’ll tell you why this often-overlooked approach may go a long way to reap some solid returns for you.
Why Rising P/E is a Valuable Tool
Investors should note that stock price moves in tandem with earnings performance. If earnings come in stronger, the price of a stock shoots up. Solid quarterly earnings and the forward guidance boost earnings forecasts, leading to stronger demand for the stock and an uptrend in its price.
So, if the price is rising steadily, it means that investors are assured of the stock’s fundamental strength and expect some solid positives out of it. Suppose an investor wants to buy a stock with a P/E ratio of 30, it means that he is willing to shell out $30 for only $1 worth of earnings. This is because the investor expects earnings of the company to rise at a faster pace in the future on strong fundamentals.
Also, studies have revealed that stocks have seen their P/E ratios jump more than 100% from their breakout point in the cycle. So, if you can pick stocks early in their breakout cycle, you can end up seeing considerable gains.
The Winning Strategy
In order to shortlist stocks that are exhibiting an increasing P/E, we chose the following as our primary screening parameters.
EPS growth estimate for the current year is greater than or equal to last year’s actual growth
Percentage change in last year EPS should be greater than or equal to the previous year
(These two criteria point to a positive or flat earnings growth trend over the years).
Percentage change in price over four weeks greater than percentage change in price over 12 weeks
Percentage change in price over 12 weeks greater than percentage change in price over 24 weeks
(These two criteria show that price of the stock is increasing consistently over the said timeframes).
Percentage price change for four weeks relative to the S&P 500 greater than percentage price change for 12 weeks relative to the S&P 500
Percentage price change for 12 weeks relative to the S&P 500 greater than percentage price change for 24 weeks relative to the S&P 500
(Here the case for consistent price gains gets even stronger as it displays percentage price changes relative to the S&P 500).
Percentage price change for 12 weeks is 20% higher than or equal to percentage price change for 24 weeks, but it should not exceed 100%
(This criterion indicates that a 20% increase in the price of a stock from the breakout point gives cues of an impending uptrend. But a jump of over 100% indicates that there is limited scope for further upside and the stock might be due for a reversal).
In addition, we place a few other criteria that lead us to some likely outperformers.
Zacks Rank less than or equal to 2: Only companies with a Zacks Rank #1 (Strong Buy) or 2 (Buy) can get through.
Average 20-day Volume greater than or equal to 50,000: High trading volume implies that the stocks have adequate liquidity.
Just these few criteria narrowed down the universe from over 7,700 stocks to just nine.
Catabasis Pharmaceuticals Inc. CATB: It is a biopharmaceutical company. It has a Zacks Rank #2. It hails from a top-ranked Zacks industry (top 35%).
Ligand Pharmaceuticals Incorporated LGND: It discovers, develops and markets drugs that address critical unmet medical needs in the areas of cancer, pain, skin diseases, hormone-related diseases, osteoporosis, metabolic disorders, and cardiovascular and inflammatory diseases. It has a Zacks Rank #2 and it belongs to a top-ranked Zacks industry (top 35%). You can see the complete list of today’s Zacks #1 Rank stocks here.
Key Energy Services Inc. : This Zacks Rank #2 company is an onshore, rig-based well servicing contractor. It comes from a top-ranked Zacks industry (top 36%).
Carbonite Inc. CARB: This is a computer service company which provides online backup solutions for consumers and small and medium sized businesses to retrieve files if lost on the Internet. The stock has a Zacks Rank #2. . It belongs to a top-ranked Zacks industry (top 9%).
Second Sight Medical Products Inc. EYES: This Zacks Rank #2 medical device company comes from a top-ranked Zacks industry (top 38%).
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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: https://www.zacks.com/performance.