P/E Ratios
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?
Article comments
With a title like that, I had to respond. As a portfolio manager of stocks, bonds, cash for a privately held corporation, I had to give my 2 cents worth. First off, investing in individual stocks requires a tremendous amount of research, reading annual reports, analyzing financial ratios, checking competitors, evaluating historical data and comparing with current trends, understanding growth drivers etc., Examining PE ratios is just one tiny piece of the picture. The most successful investors buy a stock when it’s valuation as measured by PE and other metrics is in the lower range of it’s historical average. That said, PE can be used as a sniff test for a stock to determine whether you want to investigate further. So, in answer to the question-YES, definitely use a PE. But I’m also moving more toward index and etf investing!!! Thanks for a thought provoking post with an open door to a great conversation.
“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”
Warren Buffett (and his checkbook) would disagree; his recent pledge to donate the vast majority of his personal wealth to charitable causes included this statement: “My luck was accentuated by my living in a market system that sometimes produces distorted results”.
I rather like a book called Rule # 1 Investing by Phil Town, which has a highly practical method to find those ‘market distortions’ … at least, when it comes to individual stocks. P/E is just one of the measures that he uses; another is Earnings Per Share growth.
BTW: stock splits don’t affect the P/E ratio, because both Price and Earnings are ‘split’ 🙂
I’m with Curmudgeon, PE is the price. I also like the mention of Shiller’s PE as it’s a good stat that says the market is overvalued. I’d say PE is a good intermediate investor stat. But for someone that’s just getting started in investing it should be largely ignored until they know how to tie a balance sheet to an income statement.
PE is the first thing I want to know about a stock. I guess I really think of it as the price. Ultimately, stocks are only worth something because they are a share of future profits, and understanding what you are paying per dollar of those profits is what it is all about. Of course, a PE is just a snapshot, what you are paying per dollar of last year’s profits, but that’s a great place to start.
Price, the dollars per share that the stock trades at now, is, in and of itself, basically worthless. That Apple and Google haven’t bothered to split doesn’t tell you very much, if anything at all.
Just my non-humble opinion.
Don’t forget the grand-daddy of them all, Berkshire Hathaway (A Class) shares, which never has split since it’s inception.
http://finance.yahoo.com/q?s=BRK-A
Currently trading at $116,141 a share. I believe it is the most expensive stock per share.
P/E should only be one of the things an investor should be considering when looking at an investment. An investor should consider price to book value, debt to equity, return on equity, as well as other ratios.
I agree with Investor Junkie’s point. P/E is an imperfect indicator. Most investing websites track trailing P/E (last year’s earnings) while could be much higher than this year’s. If a $10 stock made $2 last year, it would seem very attractive from a P/E standpoint. If that company only expects to only make 50 cents this year, then it isn’t that attractive.
As for looking at price when buying, I think it’s important. For every stock I buy, I establish a price target. I only typically buy stocks that are below $25, that have spent considerable time at higher levels. Usually I’m going for at least a 100% price appreciation.
I’m just starting to invest so I’m not currently looking at P/E ratios, but would be interested to know what stocks have good P/E ratios right now. Do you know this? Or know a good site to find that information?
Hi Jenna. See my above post for the entire market. If you look at the P/E over 10 year avg (which smooth things out) we are slightly above average. In simple terms, things are not cheap at 19.41, but they are lower than previous.
For specific stocks you can visit Google’s or Yahoo’s finance section. As far as the lowest P/E stocks on the stock market, keep in mind low P/E does not equal a great investment. A stock can have a low P/E for other reasons, that may not make it an attractive buy. Don’t buy a stock JUST because it has a low P/E.
Hope this helps..
For example: BP’s PE is 5.6 whereas Visa’s is 22.1. BP looks like a value but investing on that notion alone is… risky to say the least.
Great example! Thanks the weakonomist!
“When I do invest in companies, I look mainly at stock price.”
Isn’t stock price completely arbitrary due to stock splits? If a stock is at $100 a share one day and then splits 2 for 1, the next day it is $50. Nothing about the company has changed, but the price of a share of stock has drastically changed. It seems share price should have very little to do with your decision to invest in a company. The only exception I could see to that would be if the stock price were at the extremes, such as a penny stock or berkshire hathaway.
“Do you look at P/E ratios when you invest?” Yes BUT it should not be the only factor when determining should you invest. Also a great site that shows the P/E Ratio from Robert Shiller’s data can be found here:
http://www.multpl.com/
It’s a rolling 10 year P/E ratio.
Using P/E means you are following a value investor philosophy. Nothing wrong with this methodology (as I believe it is the best method for a retail investor), but you have to consider a stock with a low P/E may or not be a good stock to invest in. The analogy is like buying clothing on sale. Is it really on sale, or was it marked up and discounted? (meaning it’s really not cheap). In addition, you shouldn’t buy an ugly Hawaiian shirt no matter how cheap it is. You’ll never wear it
From the NYT article about Jeremy Siegel I finally got on my Kindle his book “Stocks for the Long Run”. So far a great book BTW and inline with greats from William Bernstein and Benjamin Graham.