Sometimes you can look at a stock and all the indicators point toward it being cheap, but because of where the company is in its cycle, it's not.
Probably best to say what a cycle is. For a market cycle, to put it simply, things don't move in straight lines, and demand and supply vary over time. This is driven by the broader economy, and is not really controllable by the company. However there are periods of increasing demand followed by decreasing demand, and obviously this needs to be balanced with supply. The length of cycles varies depending on the type of good. During those ups revenue grows and so do margins, on the downs sales decreases and margins decrease with it.
If you want real life examples of this just look at iron ore prices and the big iron ore companies. However I want to focus on company cycles and normalisation of earnings.
Effectively a companies margins will change as the focus changes. I.e. a company in a growth phase will have lower margins and when it comes out of a growth phase, increasing margins. This is largely linked to expenditure, which impacts margins, and the size of that impact depends on the companies degree of operating leverage (In short: Look at the amount of costs that are fixed. If a higher proportion are fixed costs, there is a bigger impact on margins).
Lets look at this from a mining companies view - normalise output:
Lets say you mine gold. Hypothetically, lets say you on average get 10 ounces of gold for every 20 tons of rock mined, over the last 5 years. Now some periods of mining you will get 15 ounces and others you will get 8 ounces, or 10 or 6 etc. All of this time you are mining the same amount of rock. So your cost to mine is the same. Lets say $10 000 per 20 tons. Lets also assume gold sells for $1300 an ounce.
Period 1: In a good period you mine 15 ounces and make $19 500 it costs you $10 000 and you make a profit of $9 500. So your margin is 48%.
Period 2: In a bad period you mine 8 ounces and make $10 400, it still costs you $10 000 and your profit is $400. So now your margin is 3.84%.
Lets say the market cap in period 1 is $50 000. Your PE ratio would be 5.26.
In period 2 lets say the market cap is $30 000. You PE ratio would be 75.
When is the company (share) cheaper? This is where value investors can easily get it wrong.
The value of a company is the discounted future cash flows. General PE's are historic and don't reflect the future. So in this example we would expect the future period to yield 10 ounces (Normal output) and make a profit of $3 000. Would you rather pay $50 000 or $30 000 for the future earnings? This is why you need to normalising earnings.
If in period 2 the market cap was $50 000 your PE would be 125, and the company would look expensive compared to period 1, but it is effectively the same price.
Now lets look at a "normal" companies - normalise margins:
If you were looking at the value of a company, growth is important and the ability to convert that into cash profit is important. As with output above you need to do the same thing with margins. This could be due to acquisitions, changes within the business operations, expansions, restructuring or various other reasons. So lets use a franchise company for simplicity.
So you find a company and you do some research and see that the industry operating margins are on average 10% (let us just assume, for simplicity, that operating profits convert to cash flow). The average PE ratio in the industry is 16.
Company A has a margin of 12% and a PE of 17, it is a large company with stable earnings.
Company B has a margin of 6% and a PE of 20, company B is medium size but has been spending money on re-branding its stores, marketing and some expansion.
Again which company is cheaper?
Again taking a purely value investing approach might give you the incorrect answer. In this case you need to normalise margins. If company B in the future stops the costs associated with re-branding, marketing and expansion (it will cut back in discretionary costs), so expenses will drop, but revenue will still grow from the past investment (although likely slowing growth). In this process the margins will start increasing. So lets assume company B manages to increase margins to to 9% (50% increase). Your PE ratio would now drop to 13.33, and company B would be a more attractive investment than company A.
Long and short of the story. When looking to buy a stock, you need to look at where the companies margins are in relation to their norms. Look if the company's margins will be increasing, remaining stable or decreasing (Normally you get this by looking at historic averages - industry, competitors and company). You also need to understand the bigger economic cycle.
What you want, is a company with low earnings/margins (compared to norm) on a low PE. What you don't want is a company with high earnings/margins and an average PE.