Understanding the stock market through the price-earnings ratio

By Keith Anderson

The price-earnings ratio, or P/E, is the most commonly quoted investment statistic, but have you ever considered what it actually means? For most people it’s a shorthand way of deciding how highly the market regards a company, with investors prepared to overpay for earnings from a high-P/E ‘glamour’ stock as opposed to a low-P/E ‘value’ stock. However, academics have known since 1960 that the opposite is true: value stocks outperform glamour stocks consistently over decades.

A company with a low P/E may have been marked down for no readily apparent reason and thus could represent an attractive value investment for those with the patience to wait while the market re-values it. However, the P/E is a backward-looking measure and just because the company earned £1 per share last year it doesn’t necessarily mean it will earn anything like that in the foreseeable future. Or, a low P/E can mean a company is deservedly cheap because it is in financial difficulty – in this case the company is likely to become cheaper yet or even go into administration.

This book is a practical guide to how you can adjust and improve the price-earnings ratio and use it, alongside other financial ratios, to run against the crowd and boost your stock returns.

After completing his BSc in Mathematical Statistics and Operational Research at Exeter, Keith Anderson worked for some years as a systems developer, most recently at Deutsche Bank in Frankfurt. He then did an MSc in Investment Analysis at Stirling, where he won the Morley Prize as the top academically in his year. For his PhD at the ICMA Centre, Reading University, Keith showed that different ways of calculating the Price-Earnings ratio could significantly improve investor returns. He worked as a lecturer at Durham University Business School for two years before moving to York in 2008. Keith has written a number of books, papers and articles.