Magic Numbers and Relative Valuations

Many people seem to believe there are some "magic numbers" out
there that equate to stock-picking success.

Two things in particular that I hear over and over again
relates to P/E Ratios and Price/Book Values.

For some reason, many people believe that P/E Ratios of 20 or
less and Price/Book Values of 1 or less are these so-called
"magic numbers".

Unfortunately, statistics prove otherwise.

Looking at the best-performing stocks of 2006, only 41%
started with P/E's (using 12-month EPS Actuals) of under 20
while the other 59% were over 20. ("Best-performing" is
qualified by stocks that were trading at $5 or higher at the
beginning of the year, traded on average of 50,000 shares a
day and that have increased in price by 50% or greater by the
end of the year.)

This may or may not sound like a big deal. But, if you limited
yourself to only those stocks with P/Es under 20, your screen
would have excluded nearly 60% of the best-performing stocks
from your radar screen. And that is a big deal.

True, there were/are stocks in there with P/Es under 20, but
you would've missed a lot of fantastic winners if you excluded
those over 20.

As for the Price/Book Value, the median P/B was 2.9 at the
beginning of the period and nearly 4 (that's right, 4!) by the
end. Percentage wise, only 2% of the stocks had P/Bs of less
than 1 at the start. Which means, using the `magic number' of
1 for a P/B value would have excluded nearly every top
performer of 2006.

So if you're determined to look for stocks with `low'
valuations (P/E, P/B), try looking for `low' valuations as
compared to their Industries.

Why? Because 68% of the stocks on that list of winners had
P/Es under the average for their Industry and over 62% had
P/Bs under the average for their Industry. This means the
majority of the best companies would have made it through a
relative valuation screen, giving you a chance to buy them.

-- Kevin Matras, Zacks.com