I’m not a skilled investor, particularly when it comes to short-term prognostication, and my long-term track record has yet to be established considering my first investing decision was less than ten years ago. I don’t invest in many individual stocks. My 401(k) includes company stock as part of my employer’s matching contribution, and I opted into a stock purchasing plan where I can buy more company stock at a discount. Other than that, I’ve only invested in a few companies here and there.
When I do invest in companies, I look mainly at stock price. I’m not trying to outsmart the market — any information I have about a company must already be common knowledge and included in the stock price, though David Adler, author of Snap Judgment, argues the market isn’t that efficient.
I tend to ignore the price to earnings (P/E) ratio, though savvier investors consider this calculation more relevant for making trading decisions that the stock price. The P/E ratio is the price of one share of stock divided by the company’s earnings per share of stock, a financial line item public companies report on a quarterly and annual basis.
This can be helpful when comparing one company to another or one company to its industry average. A lower P/E ratio, particularly if the ratio is low when compared with similar companies or the industry average, could mean that company’s share price is a good deal. It could also mean there may be an underlying problem at that company.
Jeremy Siegel points out the P/E ratio for the stock market as a whole since World War II has been 15.2, implying the current lower P/E ratio of the overall market of 13 signals a good time to invest in the stock market. Wikipedia claims the P/E ratio for a longer stretch of time, the past 130 years, has been 12.1. That makes it more difficult to determine whether now is a good time to invest in the stock market.
The strategy of investing when an investment’s P/E is lower than what it should be, considering the company’s competition, relies on an assumption that investments eventually return to the mean — and in order to do so, worse-than-average performance must be followed by better-than-average performance. Reversion to the mean sounds like a solid approach, and it may hold true for long periods of time or diversified investments measured as a group, but any one investment may not follow that pattern in the time period you envision.
Do you look at P/E ratios when you invest?
Updated May 5, 2014 and originally published July 19, 2010.