Can Investors Trust The P/E Ratio?

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By 
DEREK SIMON
 
 
Updated Feb 17, 2021
TABLE OF CONTENTS

 What Goes Into the P/E Ratio?

 What's a Good P/E Ratio?
 How a "Good" P/E Ratio Has Changed
 Is the P/E Ratio Accurate? 
 Does the P/E Revert to Industry Norms?
 Can the P/E Ratio Be Adjusted?
 Key Points to Consider About P/E
 The Bottom Line

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 based on the price of a
company's shares relative to its earnings.

Trailing P/E takes the current share price divided by the total earnings per share
(EPS) over the past 12 months. Forward P/E instead uses the current share price
divided by expected EPS forecast over some future period. The resultant figures
can provide valuable insight into the quality of an investment, though just how
clear a view is still up for debate. 

KEY TAKEAWAYS

 Price/earnings (P/E) ratios are used to assess the relative attractiveness of

a potential investment based on its market value.
 Value investor Benjamin Graham believed that P/E ratios were not an
absolute measure, but rather a "moderate upper limit" to be considered by
investors.
  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 Goes Into the 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 $0.50, the
company has a P/E of 20 =($10/0.50). If the EPS rose to $0.75 with the stock
remaining at $10, the P/E would fall to a more attractive or conservative valuation
of 13 = ($10/0.75).

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 $0.25, the P/E
would fall to 8 = ($2/0.25). Although eight is a lower P/E, and thus technically a
more attractive valuation, it's also likely that this company is facing financial
difficulties leading to the lower EPS and the low $2 stock price.

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."1

Graham thus asks, "Does that mean all companies with a P/E of 16 have the
same value?" His answer is, "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 Has 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, some 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."2

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 15.2 The Dow is the Dow Jones Industrial Average (DJIA), which tracks
the stocks of 30 well-established blue chip companies in the U.S. In other words,
by Graham's standards, these supposedly solid and mature stocks were
overvalued. 

Does the P/E Revert to Industry Norms?

In theory, stocks trading at high multiples will eventually revert 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 during other 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.3