P/E ratios explained

What Does Price-Earnings Ratio - P/E Ratio Mean?

A valuation ratio of a company's current share price compared to its per-share earnings.

Calculated as:

For example, if a company is currently trading at $43 a share and earnings over the last 12 months were $1.95 per share, the P/E ratio for the stock would be 22.05 ($43/$1.95).

EPS is usually from the last four quarters (trailing P/E), but sometimes it can be taken from the estimates of earnings expected in the next four quarters (projected or forward P/E). A third variation uses the sum of the last two actual quarters and the estimates of the next two quarters.

Also sometimes known as "price multiple" or "earnings multiple".

Price-Earnings Ratio - P/E Ratio

In general, a high P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E. However, the P/E ratio doesn't tell us the whole story by itself. It's usually more useful to compare the P/E ratios of one company to other companies in the same industry, to the market in general or against the company's own historical P/E. It would not be useful for investors using the P/E ratio as a basis for their investment to compare the P/E of a technology company (high P/E) to a utility company (low P/E) as each industry has much different growth prospects.

The P/E is sometimes referred to as the "multiple", because it shows how much investors are willing to pay per dollar of earnings. If a company were currently trading at a multiple (P/E) of 20, the interpretation is that an investor is willing to pay $20 for $1 of current earnings.

It is important that investors note an important problem that arises with the P/E measure, and to avoid basing a decision on this measure alone. The denominator (earnings) is based on an accounting measure of earnings that is susceptible to forms of manipulation, making the quality of the P/E only as good as the quality of the underlying earnings number.

Value investing

I definitely fall under the category of value investor. I like the idea of buying stocks for less than they are worth. Who wants to pay full price, don't we all like a sale?
Well here is some information on what value investing is.

Value investing is an investment that derives from the ideas on investment and that Ben Graham began teaching at Columbia Business School in 1928 and subsequently developed in their 1934 text Security Analysis. Although value investing has taken many forms since its inception, it generally involves buying a stock whose shares appear under priced by some form(s) of fundamental analysis. As examples, such securities may be stock in public companies that trade at discounts to book value or tangible book value, have high dividend yields, have low price-to-earning multiples or have low price-to-book ratios.

High-profile proponents of value investing, including Berkshire Hathaway chairman Warren Buffett, have argued that the essence of value investing is buying stocks at less than their intrinsic value. The discount of the market price to the intrinsic value is what Benjamin Graham called the "margin of safety". The intrinsic value is the discounted value of all future distributions.

However, the future distributions and the appropriate discount rate can only be assumptions. Warren Buffett has taken the value investing concept even further as his thinking has evolved to where for the last 25 years or so his focus has been on "finding an outstanding company at a sensible price" rather than generic companies at a bargain price.

Benjamin Graham

Benjamin Graham Value investing was established by Benjamin Graham and David Dodd, both professors at Columbia Business School and teachers of many famous investors. In Graham's book The Intelligent Investor, he advocated the important concept of margin of safety — first introduced in Security Analysis, a 1934 book he coauthored with David Dodd — which calls for a cautious approach to investing. In terms of picking stocks, he recommended defensive investment in stocks trading below their tangible book value as a safeguard to adverse future developments often encountered in the stock market.

Further evolution

However, the concept of value (as well as "book value") has evolved significantly since the 1970s. Book value is most useful in industries where most assets are tangible. Intangible assets such as patents, software, brands, or goodwill are difficult to quantify, and may not survive the break-up of a company. When an industry is going through fast technological advancements, the value of its assets is not easily estimated. Sometimes, the production power of an asset can be significantly reduced due to competitive disruptive innovation and therefore its value can suffer permanent impairment. One good example of decreasing asset value is a personal computer. An example of where book value does not mean much is the service and retail sectors. One modern model of calculating value is the discounted cash flow model (DCF). The value of an asset is the sum of its future cash flows, discounted back to the present.

Performance, value strategies

Value investing has proven to be a successful investment strategy. There are several ways to evaluate its success. One way is to examine the performance of simple value strategies, such as buying low PE ratio stocks, low price-to-cash-flow ratio stocks, or low price-to-book ratio stocks. Numerous academics have published studies investigating the effects of buying value stocks. These studies have consistently found that value stocks outperform growth stocks and the market as a whole.

Performance, value investors

Another way to examine the performance of value investing strategies is to examine the investing performance of well-known value investors. Simply examining the performance of the best known value investors would not be instructive, because investors do not become well known unless they are successful. This introduces a selection bias. A better way to investigate the performance of a group of value investors was suggested by Warren Buffett, in his May 17, 1984 speech that was published as The Superinvestors of Graham-and-Doddsville. In this speech, Buffett examined the performance of those investors who worked at Graham-Newman Corporation and were thus most influenced by Benjamin Graham. Buffett's conclusion is identical to that of the academic research on simple value investing strategies--value investing is, on average, successful in the long run.

During about a 25-year period (1965-90), published research and articles in leading journals of the value ilk were few. Warren Buffett once commented, "You couldn't advance in a finance department in this country unless you taught that the world was flat."