Can Investors Trust the P/E Ratio? (2024)

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 theP/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.

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 (NI) 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.

If, for example, 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."

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

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 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.

Over the last 20 years there has been a gradual increase in P/E ratios as a whole, despite the fact that 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 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.