Every few years or so the market gets pessimistic on stocks and individual companies go on sale at depressed levels. But how can investors tell if pessimism is high enough to warrant a purchase of a particular stock? In The Investment Zoo, Stephen Jarislowsky suggests looking at a company's historical P/E over time in order to determine whether a stock is relatively cheap.
As an example, here's a look at Coke's (KO) P/E over the last several decades:
We can clearly see that the market is currently quite pessimistic on this stock relative to its history. We can also see what a great bargain this brand name company was in the early 80s when stocks were quite unpopular.
Of course, this is far from a perfect method to determine if a stock is cheap. As companies transition from start-ups to growth companies to mature companies, one would expect that the company's appropriate P/E would actually change over time.
Furthermore, just because a company's historical P/E has traded within a certain band does not mean that will continue into the future. You still have to ensure you understand the company's situation (including its financial statements) before jumping in. Nevertheless, an examination of this nature can help identify stocks that may be oversold and thus warrant further analysis.