The Blattistics Adjusted P/E Spreadsheet provides a powerful tool to identify stocks which may be underpriced. The following is a tutorial based on two sample entries from the Adjusted P/E Spreadsheet for May, 2009:




What Does it All Mean?

The first thing you should do is sort the spreadsheet. The most useful number is the Adjusted P/E column. You may also want to filter the results by market capitalization if you prefer investing in stocks in a certain size range. The P/E ratio gives the number of years that it would take for the earnings from the previous year to equal the price or market capitalization of the stock. A stock with a low P/E ratio is predicted to reach its current value in profits alone in a shorter amount of time. In general, stocks with low P/E ratios are undervalued and stocks with high P/E ratios are overvalued. New companies that are expected to grow rapidly will have much higher P/E ratios and are not necessarily overvalued. Only stocks with positive trailing twelve month earnings are shown. If the stock's earnings are very close to zero, the stock's P/E ratio may be arbitrarily high.

Why Adjust P/E Ratios?

The crude P/E number is misleading. One way to estimate a stock's value is to estimate its market capitalization or price if it were acquired. Consider a company with a market capitalization of $90 million, $10 million dollars in annual earnings, and $50 million in cash on hand. Now consider a company with a market capitalization of $60 million, $10 million in annual earnings, and $10 million in cash on hand. The first company has a P/E ratio of nine. The second company has a P/E ratio of 6. However, if a firm acquired both companies it could distribute the cash on hand to pay for the acquisition. If this cash is subtracted from the market capitalization, the first company has an adjusted P/E ratio of 4, and the second company has an adjusted P/E ratio of 5. Adjusted P/E "adjusts" the price of the stock by removing cash on hand and adding in the total debt obligation of the company. A company with an Adjusted P/E lower than its actually P/E indicates that it has a high level of cash on hand and a low level of debt. A company with an Adjusted P/E higher than its actual P/E has a low amount of cash on hand and a high amount of debt. In the example shown above Knight Capital Group (NITE) may be an undervalued stock, whereas Ryder Systems (R) may be overpriced.

What Should I Look For?

A low adjusted P/E (less than 5) is a strong sign that a company is undervalued. Consider the following factors which may distort results:
-Stocks with high projected earnings growth will have higher P/E ratios than stocks with low projected earnings growth.
-Some sectors such as pharmaceuticals rely on high amounts of cash on hand. This model does not make any sector adjustments.
-Stocks that don't give out dividends will have more cash on hand and are more likely to have major differences between their actual and Adjusted P/E ratios.
Thank you for your interest in Blattistics and good luck.

Blattistics regressions can also be used to identify value stocks. Click here to read a tutorial on how to use Blattistics regressions for identifying value stocks.

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