When P/E Ratios Matter

  • Posted by
  • on February 26th, 2011

Before you read this, I encourage you to read the book excerpt that inspired this by one of my favorite researchers Ed Easterling.  He explains in great detail the relevance of starting P/E ratios in determining the success or failure of long-term investing and its impact on withdrawal rates.  I think his book Unexpected Returns is the seminal work on secular market valuations, and I’m thrilled he’s written another book.

Price-earnings ratios are very controversial, and I believe much of the debate is misguided.  The thought that Company X is a better buy than Company Y because it has a P/E ratio of 13 vs. 20 is ludicrous to me.  There are a number of factors driving P/E ratios, from interest rates to growth rates to profit margins to sentiment.  Some of these are market-driven, some are sector-driven, and some are company-driven.  Know what happens when you multiply a guesstimate of P/E ratio to a guesstimate of earnings…you get a guesstimate of a price target.

It makes for a nice soundbite, but this isn’t research it’s arithmetic.  I don’t discount the fact that fundamental value is a key factor in determining future price, just that P/E ratio is not the metric of choice.  Price to sales?  Sure, I can buy that one…it’s much harder for a company to fudge, and offers a glimpse into the potential for financial or corporate restructuring.

P/E ratios are not relevant for lesser timeframes, as any impact on valuation is going to be a slow crawl compared with the speed with which earnings growth can change.  What about the big bad event where a competitor or private equity firm sees value and delivers an overnight price spike with a buyout offer?  It’s highly doubtful they use P/E ratio as the metric; a competitor comes in when it sees an opportunity to grow their business or remove competition, and an investor steps in when he or she sees a chance to unlock value.  If the P/E is low it’s partly because the “E” part is high already…what value is there to unlock?

Again, don’t take my disregard for P/E ratios as a knock on value investing.  I think value investing has proven itself to be a robust form of analysis and done properly is a great path to long-term prosperity.  Tweedy Browne, Oakmark, Fairholme, Longleaf, Third Avenue, & Dodge and Cox are among the shops offering access to this style through open-ended no-load mutual funds.  Or you can follow smart services like AlphaClone or Market Folly or Todd Sullivan to see how the mind of a true value investor thinks and what situations may offer deep value.  I incorporate value investing but outsource it to some of the smart folks I’ve just listed in order to focus on my true competencies of portfolio construction and relative strength analysis.

Read Ben Graham or John Templeton or Seth Klarman to learn how they value individual stocks.  Visit Ed Easterling’s site to learn a relevant use for P/E ratios.  Grab Jim O’Shaughnessy’s book on Kindle for $5 and see how price/sales ratio combined with price momentum delivered outsized returns through the 20th century.  Just place P/E ratios in their proper place, as an important way to measure the risk and reward of potential stock market returns over the next 7-10 years but NOT the potential of a stock over the next few months.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

blog comments powered by Disqus
Derek Hernquest Blog