Understanding P/E ratio: What value does it hold for investors?

In recent decades the P/E has been the most important and best-known investment ratio. Indeed, apart from the share price, it is the only investment statistic that is published in print every day. Every share quoted in London has its P/E printed daily in the Companies section of the Financial Times. The P/E also has a strong intuitive meaning: it tells you how many years? worth of future earnings you are paying in order to buy the share now.

One might ask why there hasn?t been a book before on the P/E.

On the other hand, if you are a fund manager, the P/E or something based on it will be just one of the battery of ratios you use. You will have a filter of many different investment ratios that all of your investment universe must pass. The computer does the filtering for you, and presents you with a list of all the stocks that are interesting enough to be worth investigating further. The P/E is an integral but probably minor part of that process, and you would no more expect a book on the P/E than on ROCE or EBITDA.
While the value to investors of being familiar with this widely used statistic is clear, professionals in financial markets may find it a more surprising subject, possibly never having stopped to think how or why it is calculated that way. Such professionals may well be surprised by how easily the P/E could be improved if things were done slightly differently.

What?s interesting about the P/E?

The P/E tells you how many years of future earnings you are willing to pay to own a company?s shares now.

What more is there to tell?

I first became interested in investing my own money in the stock market over ten years ago. Bored by a comfortable but limited existence at Deutsche Bank, I took a year out to do an MSc in Investment Analysis. While I was looking round for a dissertation topic I read Graham and Dodd?s 1934 classic Security Analysis. One of their suggestions was that you should not judge a company?s earnings potential over just the last year, but take a longer term view of 7-10 years to allow for fluctuations in the economy as a whole. This seemed such a common-sense suggestion, and yet after searching through dozens of academic papers, as far as I could tell no-one had thought to test Graham and Dodd?s assertion in the 70 years since. Being a new idea to the academic world the idea took a bit of explaining to my supervisor, but the results from the limited tests I was then able to do were promising.

Since then I have gone on to do a PhD in how to improve the P/E ratio as a predictor of investor returns, some of which is updated and summarised here.

The long-term P/E and decomposing the P/E are, I feel, surprisingly rich and complex stories. I have also taught much of this book?s contents to some thousands of undergraduate and Masters students at Durham University and the University of York, a few of whom I hope have shared my enthusiasm.

But the story of the P/E is not a dry academic investigation. It is a practical guide to how any stock market investor can put an improved P/E to use.

The faults of the P/E

Even a novice private investor should know that the P/E has some glaring faults. A low P/E may mean a company that has been marked down for no readily apparent reason, and thus 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, based on one large number (sales last year) minus another large number (total costs last year). Just because the company earned £1 per share last year doesn?t necessarily mean it will earn anything like that for the foreseeable future. A low P/E can also easily mean a company that is deservedly cheap because it is in financial difficulty, and that it is likely to become cheaper yet or even go into administration.

From a different point of view, in the world of academic finance the P/E has been largely forgotten as an investment ratio for researchers since the early 1990s. Its power to identify cheap shares that will perform was first shown in 1960, but in the last 15 years few papers have been written on it. The P/E has simply shown itself not to be as powerful an indicator of a value share as several other similar measures available.
In particular the P/E was left out of Fama and French?s three-factor model of stock returns (which I cover in Part II). This model has, in the academic world at least, become the most popular way of explaining the returns that can be expected from holding the shares of various types of company.

Putting right the faults in the P/E

It is these failings that I seek to put right in Parts III and IV. Comparing a company?s share price to its earnings is still a major basis of analysis for many value investors, but the pitfalls are numerous. This book explains how the P/E?s weaknesses can be overcome.

The short-term bias of the traditional P/E is easily overcome. The fact that the P/E is largely conditioned by the overall market P/E, the company?s size and the sector in which it operates, takes some rather more complicated adjustment but can still be done using freely available information. These adjustments put in your hands a tool that is much more finely tuned to revealing shares that are good value.

The other important thing the P/E does not tell you is whether a company is in trouble. As the history of the Naked P/E (explained later in the book) attests, building your portfolio on the basis of one statistic, however clever it may be, can lead to catastrophe during a market crash. Luckily, most of this risk can be avoided if you are prepared to step outside the P/E and use complementary statistics that steer you clear of the riskiest stocks. Combining the improved P/E with a measure of a company?s current financial strength provides a simple yet powerful filter. The final result is a set of stocks that are both underpriced in terms of their earnings power, and also solvent and likely to remain so.