The goal of all investors is to buy very profitable stocks that won't cost you an arm and a leg, and aren't so high in share price that their rate of return is low. Two ways to sift through the hundreds of choices is are look at those with high net profit margins and price-earnings (P/E) ratios that aren't at sky-high levels.
What's a fair P/E ratio to pay for? Every industry is going to have a different average P/E that you can compare competitors to, but many value investors would want to see something around 15, meaning that the share price is 15 times the earnings per share (EPS) that you are buying as a shareholder when you purchase a share. If it is a lot higher than that, you may be paying a big premium on top of the real value of the stock. A higher P/E is only justified by high EPS growth.
Peter Lynch, the famous US fund manager who wrote a number of books on investing, used this as a "back of the envelope" valuation method. If a company was growing EPS annually by, say, 25%, then a PE of 25 or less could be considered.
For example, fast-growing chain stores can expand across a country for a number of years at a high rate. The trouble is how long the company can keep that pace up. If it only does it for one year, and falls back down to regular levels — 10%-15% — then you will have paid too much, and the share price will be fall as soon as the market prices that into the share price.
Here are three companies with strong net profit margins and PE ratios of 15 or less.
McMillan Shakespeare (ASX: MMS): This salary packaging administrator and vehicle fleet management service provider achieved 18.99% net profit margin and has a P/E of 13.5. Recently, its share price was brought down from $18.00 suddenly due to proposed legislative changes in Fringe Benefits Tax that would have severely affected business and earnings.
The proposals will now not be going through with the new Liberal government in power, so the short-term hit in share price offered quick-moving investors a window to buy the stock at discounted prices.
Iron ore giant Rio Tinto (ASX: RIO) has come down in price like other miners from the commodities market slump, but it is planning to increase its iron ore production and exporting to build up volume until spot prices recover.
Its 18.25% net profit margin is slightly lower than its average, but still strong. Currently its 12.7 PE ratio reflects the expected decrease in EPS over the next year, but it is forecasted to improve from there on out, so start following the story, and have your position ready when the industry picks up.
Oil and gas developer and producer Woodside Petroleum (ASX: WPL) has had net profit margins of over 30% for the past seven years. Revenues have been rising over the past four years, so if it can sustain that increase and keep up margins, earnings will grow along with them.
Its P/E ratio is 15.6, which matches the earnings EPS growth of 18.35% it had in 2012, but this year's analyst forecasted EPS growth is actually down, so that explains why it is as low as it is now.
Earnings and earnings growth are what drives the share price, so if the company can get its profits increasing like before, this may be a short-term opportunity for investors to buy at a weak point in the market.
Foolish takeaway
These two ways to separate strong stocks from the weak are just the beginning of your stock-picking research. Sometimes P/E ratios are low for a very good reason, so you have to find out why. Market sentiment for a particular industry may be way down, creating bargains for the good companies within it. Other times, the company's ability to grow profits have been either hurt or delayed.
By studying companies and their industries, you will develop a sense of what's normal or irregular, and it is in those times when the share price doesn't match the real value of the company that you can find a great buy, and lock in a great rate of return.
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Motley Fool contributor Darryl Daté-Shappard does not own shares in any company mentioned.
