Can Investors Trust The P/E Ratio?

Investing

Initially popularized by the legendary value investor Benjamin Graham (one of Warren Buffett‘s mentors), few stock market metrics have cycled in and out of favor as often as the P/E ratio. Price/earnings ratios are used to assess the relative attractiveness of a potential investment. Trailing P/E uses the current share price and divides by the total earnings per share (EPS) over the past 12 months. Forward P/E uses the current share price and divides by expected EPS in the future period. The resulting number can provide insight into the value of an investment, though just how clear a view is still up for debate. 

Key Takeaways

  • Price/earnings ratios are used to assess the relative attractiveness of a potential investment.
  • Value investor, Benjamin Graham, believed P/E ratios weren’t an absolute measure, but rather a “moderate upper limit.”
  • Whether a company’s P/E is a good valuation depends on how that valuation compares to companies in the same industry.
  • Be wary of stocks sporting high P/E ratios during an economic boom since they could be overvalued.

What Makes up a P/E Ratio?

The P/E ratio measures how cheaply valued a company’s stock price is by comparing the current stock price to its earnings-per-share (EPS). Earnings are synonymous with net income or profit while EPS is calculated by dividing net income by the total number of a company’s outstanding equity shares. If EPS rises and the stock price remains the same, the P/E will fall. As a result, the stock would have a cheaper valuation since investors would receive more earnings relative to the company’s stock price.

For example, if a company’s stock price is $10, and its EPS is $.50, the company has a P/E of 20 ($10/.50). If the EPS rose to $.75 with the stock remaining at $10, the P/E would fall to a more attractive or conservative valuation of 13 ($10/.75).

It’s important to note that a lower P/E can also be a sign of trouble. If the same company’s stock price fell to $2 per share while its EPS fell to $.25, the P/E would fall to 8 ($2/.25). Although eight is a lower P/E, and technically a more attractive valuation, it’s likely that the company is facing financial difficulties leading to the lower EPS and the $2 stock price.

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Conversely, a high P/E ratio could mean a company’s stock price is overvalued. However, the higher P/E ratio can also mean that a company is growing with its stock price and EPS both rising. A rise in the P/E ratio for a company could be due to improving financial fundamentals, which could justify the higher valuation. Whether a company’s P/E represents a good valuation depends on how that valuation compares to other companies in the same industry.

What’s a Good P/E Ratio?

In his book Security Analysis, which was first published in 1934, Graham suggests that a P/E ratio of 16 “is as high a price as can be paid in an investment purchase in common stock.”

Does that mean all 16s have the same value? No.

“This does not mean that all common stocks with the same average earnings should have the same value,” Graham explained. “The common-stock investor will properly accord a more liberal valuation to those which have current earnings above the average, or which may reasonably be considered to possess better than average prospects.”

To Graham, P/E ratios were not an absolute measure of value, but rather a means of establishing a “moderate upper limit” that he felt was crucial in order to “stay within the bounds of conservative valuation.” He was also aware that different industries trade at different multiples based on their real or perceived growth potential. 

How a “Good” P/E Ratio Changed Over Time

Of course, this moderate upper limit was all but abandoned some 20 years after Graham’s death, when investors flocked to buy any issue ending in “.com.” Some of these companies sported P/E ratios best expressed in scientific notation. Even before the dotcom madness of the 1990s, there were those who believed that comparing a stock’s price to its earnings was shortsighted at best and pointless at worst.

Is the P/E Ratio Accurate? 

According to William J. O’Neill, the founder of Investor’s Business Daily, A P/E ratio is not accurate every time as he asserts in his 1988 book How to Make Money in Stocks. He concluded that “contrary to most investors’ beliefs, P/E ratios were not a relevant factor in price movement.”

To demonstrate his point, O’Neill pointed to research conducted from 1953 to 1988 that showed the average P/E ratio for the best-performing stocks just prior to their equity explosion was 20, while the Dow’s P/E ratio for the same period averaged 15. The Dow is the Dow Jones Industrial Average (DJIA), which tracks the stocks of 30 well-established companies in the U.S. In other words, by Graham’s standards, these soon-to-be-superstar stocks were overvalued. 

Does P/E Revert to Industry Norms?

In theory, stocks trading at high multiples will eventually revert back to the industry norm–and vice-versa–for those issues sporting lower earnings-based valuations. Yet, at various points in history, there have been major discrepancies between theory and practice when high P/E stocks continued to soar as their cheaper counterparts stayed grounded, just as O’Neill observed. On the other hand, the reverse has held true during other time periods, which then supports Ben Graham’s investment process.

Further, over the last 20 years, there has been a gradual increase in P/E ratios as a whole, despite the fact the stock market has been no more volatile than in years past. Using data presented by Yale University Professor Robert Shiller in his 2000 book Irrational Exuberance, one finds that the price-earnings ratio for the S&P 500 Index reached historic highs toward the end of 2008 through the third quarter of 2009. The index posted a remarkable 38% gain during the same period, despite abnormally high investment ratios.

Years Median P/E Ratio
1900-1910 13.4
1911-1920 10.0
1921-1930 12.8
1931-1940 16.2
1941-1950 9.5
1951-1960 12.6
1961-1970 17.7
1971-1980 10.4
1981-1990 12.4
1991-2000 22.6
2001-2010 22.4

Table: S&P 500 Index Median P/E Ratios

Source: Schiller, Robert. “Irrational Exuberance” [Princeton University Press 2000, Broadway Books 2001, 2nd ed., 2005]

Can the P/E Ratio Be Adjusted?

Was O’Neill right to assume P/E ratios have no predictive value? Or that, in today’s technology-driven economy, the ratios have become passe? Not necessarily. The key to effectively using P/E ratios, many experts claim, is to examine them over longer periods of time while integrating forward-looking data such as earnings estimates and the overall economic conditions.

PEG ratios present a straightforward way to accomplish this analysis. Made fashionable by famed money manager Peter Lynch, PEG ratios are similar to P/E ratios but are divided by annual EPS growth to standardize the metric. For example, if a company has a P/E of 10 and a growth rate of 5%, its PEG ratio would be 10/5 = 2. The rationale behind PEG ratios is that higher growth prospects justify a higher P/E ratio. Therefore, if the P/E ratio is the same for two companies, the one with the higher growth rate, i.e. a lower PEG ratio is better since it costs less for each unit of growth. One Up on Wall Street (first published in 1989) Lynch wrote, “the P/E ratio of any company that’s fairly priced will equal its growth rate.” 

Key Points to Consider About P/E

Many of those who follow a rigorous fundamental analysis approach to investing still find P/E ratios quite useful. Many cite the pop of the tech bubble in the early 2000s as a prime example of the sticky mess investors can find themselves in when they don’t take heed of earnings and price. When applying fundamental analysis of a P/E ratio, there are some key factors to consider.

1. It is best to compare P/E ratios within a specific industry. This helps ensure the price-earnings performance is not simply a product of the stock’s environment.

2. Be wary of stocks sporting high P/E ratios during an economic boom. The old saying that a “rising tide lifts all boats” definitely applies to stocks–even many bad ones. As a result, it’s wise to be suspicious of any upward price movement that isn’t supported by some logical, underlying reason outside of the general economic climate.

3. Be equally dubious of stocks with low P/E ratios that appear to be waning in prestige or relevance. Over the years, investors have seen a number of formerly solid companies have financial difficulties. In these instances, it’s foolish to think the price will magically increase to match the earnings and boost the stock’s P/E ratio to a level consistent with the industry norm. It is far more likely that any P/E increase will be the direct result of eroding earnings or lower EPS, which isn’t the way investors would like to see a bullish rise in a company’s P/E.

The Bottom Line

While investors are probably wise to be wary of P/E ratios, it is equally prudent to keep that apprehension in context. While P/E ratios are not the magical prognostic tool some once thought they were, they can still be valuable when used in the proper manner. Remember to compare P/E ratios within a single industry, and while a particularly high or low ratio may not spell disaster, it is a sign worth considering. 

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