There are 29 stocks valued above $1 billion trading on single digit PEs: Are they actually cheap?

For many investors, the price-to-earnings (PE) ratio is the bread and butter method of valuing companies. Generally speaking, a stock with a single digit PE ratio is often viewed as 'cheap'. While a figure north of 30 is generally viewed as more 'expensive'.

Currently, there are 29 companies that have a market cap of over $1bn that trade with a single digit PE ratio. That's a pretty big pool of 'cheap' and well-established companies right?

Hold your horses. There are a few things you might want to know.

Larger cap stocks with low PE ratios

Before we dive in, here's the list. (It's a long one so brace yourself for some scrolling)

Some interesting observations include:

• Top performing stocks were: Whitehaven Coal (+219.5%), Stanmore Resources (+196.6%), New Hope (+148.4%) and Yancoal (+102.8%). Aka four coal miners

• Worst performing stocks were: Summerset Group (-36.1%), Fletcher Building (-37.1%), Healius (-41.1%) and Magellan Financial Group (-56.7%).

• Average 12-month return among the 29 companies is 14.6%

• Over the same period, the ASX 200 fell -7.5%

• Median 12-month return is -0.08%. This means the average return was heavily weighed by the outsized returns of just a few stocks (aka four coal miners)

• Excluding the four coal stocks, the average return falls to -9.7%

• 15 stocks are resource-related. Specifically, 11 from Materials, 1 from Energy and 3 from Agriculture

Understanding low PE ratios

We can bucket most of the companies on the list into two key themes:

1. Cyclicals – covers the resource-related names

2. Price leads earnings – covers various retail and beaten up names

Cyclicals: You might've heard the term commodity supercycle being thrown around in 2021-22. This reflects the ebb and flow of commodity prices, which is generally triggered by factors such as an unexpected increase in demand, changes in global economic growth and supply-related disruptions.

Source: Bank of Canada

Resource companies are no doubt a leveraged play on both the commodity cycle and commodity prices. In the context of company valuations, this is what generally happens throughout the cycle:

• High commodity prices: Share prices increase but earnings are supercharged thanks to growing margins. The jump in earnings causes PE ratios to fall. For example: Whitehaven Coal's FY22 net profit was $1.95bn compared to -$87.3m in FY21 (before significant items) and $30m in FY20

• Low commodity prices: Earnings fall as margins are squeezed. Share prices fall but PE ratios tend to rise amid a greater decline in earnings. PE ratios can even become negative for high margin producers

Under this rationale, a high PE ratio marks the bottom of the cycle while a low multiple signals the top.

Price leads earnings: The 'P' can often fall and give a stock the appearance of a low PE ratio. In the subsequent period, the 'E' then catches up (or in this case, falls). Here are a few examples of stocks from the low PE list that might fall under this category:

• Sonic Healthcare: Experienced a massive pull forward in earnings thanks to revenue from covid testing-related activities. In its latest trading update for the four months to October 2022, earnings fell -37.3% as it cycles the one-off boost from last year

• Healius: A similar narrative as Sonic Healthcare – receiving a massive boost from PCR testing-related revenues

• BlueScope Steel: A November 2022 trading update said the business expects to deliver a 'lower result than 2H FY2022'. It noted that customers were seeking to 'lower inventories in a falling price environment'

• Harvey Norman and JB Hi-Fi: High inflation and rising interest rates is expected to take a toll on Australian discretionary spending. Retail data from the Commonwealth Bank of Australia showed categories such has alcohol, clothing and footwear all experiencing large falls in spending growth in the week to 16 December 2022, according to Bloomberg

• Magellan Financial: Funds under management has fallen -56.9% for the twelve months to November 2022

The bottom line

Instead of viewing the low PE ratio scan as a place for 'cheap' stocks – it should be used as a tool for identifying opportunities where supplementary questions (examples below) can provide more context as to why the PE ratio might appear so low.

• What do futures earnings look like (analyst forecasts)

• Is it cheap relative to peers

• Is it cheap relative to the market

• Is it cheap relative to how it has traded historically