The current issue of Smart Money magazine has an interesting thought piece on why low P/E ratios can be deceiving. In the search for undervalued stocks, many investors rely on low P/E ratios as the best indicator of relative value vis-a-vis other stocks. In other words, stocks trading below their historical P/E ratios could represent a bargain, as could stocks of certain industries with average P/E ratios below those of companies in other industries.

Not so fast, says Reshma Kapadia of Smart Money. For one, P/E ratios rely on accurate forecasts of near-term earnings and, in this market, the level of visibility into corporate earnings is exceptionally murky. For another reason, there's no guarantee that the P/E ratio won't decline even further. For example, when the P/E ratios for home builder stocks dipped below 9 three years ago, many analysts called them a bargain. But, as we now know with 20/20 hindsight, they weren't.

There are two other alternatives to Price-to-Earnings proposed within the article: Price-to-Book (the firm's stock price divided by the per-share value of the company's assets) and Price-to-Sales (the firm's stock price divided by its revenue per share). Using a combination of Price/Sales and Price/Book to find possible investment targets, Reshma comes up with three possible companies - one within the troubled retail sector, one within the financial services sector, and one within the trucking & transportation sector.

NOTE: Please keep in mind that TradeKing does not specifically endorse any of the securities or trading strategies mentioned. Depending on your risk-reward profile, this trade may or may not be suitable for your portfolio. The stocks mentioned are for educational purposes only.

[image: Smart Money September 2008 cover]