Can Investors Trust The P/E Ratio?

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 some insight into the value of an investment, though just how clear a view is still up for debate. 

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, however, there were those who felt comparing a stock's price to its earnings was shortsighted at best, and pointless at worst.

Is the P/E Ratio Accurate? 

Not every time, as William J. O'Neill, the founder of Investor's Business Daily, 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. 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 where 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.

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 exam them over longer periods of time while integrating forward-looking data like earnings estimates and the overall economic climate.

PEG ratios present a simple way to accomplish this. 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 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 higher growth rate i.e. lower PEG ratio is better since it costs less for per 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."  

Fundamental Analysts Still Like P/E

People who follow a rigorous fundamental analysis approach to investing still think P/E is quite useful, citing the tech bubble pop as a prime example of the sticky mess investors can find themselves in when they don't take heed of earnings and price.

Key Points to Consider About P/E

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 - so 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. In recent years, investors have seen a number of formerly solid companies hit the skids. 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, which isn't the P/E "bounce" bullish investors are looking for.

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.