The price-to-earnings ratio, or PE ratio, is one of the simplest but most popular financial ratios for estimating the value of a stock. Even though the PE ratio is simple, it’s an amazingly useful tool.
In fact, a study by Merrill Lynch found that 33% of professional investment managers consider the PE ratio before investing in a company. And one of the most famous value investors of recent times, Peter Lynch, was known to make good use of the PE ratio in his analysis.
Historical PE ratios & stock market performance
Historically, stocks have averaged a PE ratio between 15 and 20 and if you look at a large database of companies you’ll find that most stocks sit within this range.
The stock market as a whole (measured by the S&P 500) has had an average PE ratio (throughout it’s history) of 15.54. It’s lowest ever recorded PE ratio was 5.31 (in 1917) and it’s highest ever PE was 123.73 (in May 2009).
However, Robert Shiller, the nobel laureate economist from Yale University likes to use the cyclically adjusted PE ratio instead (known as CAPE) and this gives a historical PE ratio of 16.6.
As you can see from the historical chart below, it’s obvious that at the time of writing the stock market is expensive, since it is trading well above it’s average.
That’s not a particularly good sign for today’s investors, since it means stock markets will either have to drop in price, or earnings will have to shoot up significantly.
The below table from GuruFocus shows what can be expected when the PE ratio is at various levels:
The following chart from Professor Shiller plots annualised returns vs. 10-year PE ratio for the US stock market since 1890. You can clearly see the correlation. Lower PE ratios equal better investment returns and this relationship holds through each twenty year period.
The difficulty is that there is no way to tell when the PE ratio for the stock market will adjust. That’s why individual investors can only stick to the strategies that work for them and not worry about market timing.
Individually, there will always be opportunities in stocks that buck the trend.
But unfortunately, historical PE data for individual stocks and industries is not easy to come by. Portfolio123 is a powerful simulator which contains fundamental data back to 1999 and this is the tool I used to construct the Marwood Value model, a strategy that shows 20%+ annual returns over that period.
And another interesting resource can be found in the book What Works on Wall Street, by James O’Shaugnessy. Shaugnessy runs a number of studies back to 1926 where he tests various different ratios such as the PE ratio and the price-to-book ratio.
So what is the PE ratio anyway?
Stocks usually move in the direction of their earnings over time and the PE ratio is simply a method to compare the price of a stock to it’s recent earnings.
When a company makes money it’s stock price will eventually go up and when a company loses money it’s stock price will go down. That’s how simple it really is.
So, if a company has a stock price of $40 and reports recent earnings per share (EPS) of $2, it has a PE ratio of 20 ($40/$2).
Essentially, this means that if you buy the stock at this level, you are prepared to pay for 20 times the recent, trailing earnings.
Historically, stocks have averaged a PE ratio between 15 and 20 and if you were to look through a large table of stocks you’ll find that most companies have PE ratios that sit somewhere within this range.
How to look at PE ratios
On the whole, the lower the PE ratio the better, since a low PE ratio means low expectations and those are easier to overcome.
Benjamin Graham, who was Warren Buffett’s teacher, said that a PE ratio of 8.5 indicates a company where the market is pricing in zero growth.
Meanwhile, with a trailing PE of 18.5 a company should grow earnings at 5% a year and with a PE of 48.5 a company should grow earnings at 20% a year.So let’s look at an example. The PE ratio for Delta Airlines is currently 29.39. And you can calculate that figure yourself by simply dividing the stock price by the EPS.
So in this case a PE ratio of 29 means the market expects Delta Airlines $DAL to grow its earnings by over 10% a year. It also means that investors are paying 29 times the airlines recent earnings to acquire the stock (or paying $29 for every $1 of earnings).
Is this a good deal?
Well, if you factor in things like the oil price, the size of the company, it’s competition and the outlook for the global economy, you have to ask if it is reasonable to expect the company to grow at over 10% a year?
I would suggest maybe not. A growth rate of 10% a year might not sound like much, but in reality many companies fail to achieve that amount. Companies do not always make money in a given year so getting average growth above 10% is not that common.
Sure, an exciting company like Tesla $TSLA might have been able to grow its earnings by over 20% during the last five years and Apple $AAPL may have grown earnings at close to 40% over the last five. But both these companies sell their own, unique products.
Delta on the other hand provides air travel like many others do. This is a highly competitive industry where company outperformance typically comes from smart fuel hedging and cost-cutting measures.
I do not want to single out Delta because with all companies, there comes a time when growth will slow down and the stock price will have to adjust. The PE ratio is simply a good way of measuring and evaluating this growth so you can make investment decisions.
For certain growth investors, a high PE ratio might be perfectly reasonable, and the importance of the PE ratio (like all ratios) will depend on many factors such as the industry, the product and market expectations.
Indeed, a high PE ratio can indicate a company is growing fast whereas a low PE ratio can indicate a company that is simply doing poorly and in need of assistance. As a rule of thumb, investors should prefer PE ratios within the normal range, 5-25, and ignore any company with a PE ratio above 50. They should then use other factors to back-up their analysis.
When a PE ratio is useless
In many cases of course, the PE ratio is completely useless. A tiny biotech company for example could have a PE ratio of 0 because it is still in the research stage and has yet to make any money at all. Looking at the PE ratio therefore bears no importance whatsoever.
Likewise, many company’s operate a loss-making strategy at the beginning in order to build a customer base (Amazon for example). And it’s a similar story for many resource stocks; gold miners and oil explorers, who spend huge sums up front and do not make any money until they strike lucky.
Thus, the PE ratio can only ever be a guide in certain situations and for certain companies. And when it is used it is best to use it in conjunction with other ratios and metrics.
The role of dividends
There will always be differences in PE ratios which may stem from market expectations, random fluctuations in earnings, or seasonal variations. That’s why they only ever form part of the puzzle.
One final thing to notice is that PE ratios and dividends are related, so that when the PE ratio falls, the dividend yield usually rises. This is simply a function of how the two ratios are related. Thus, when you buy a stock with a low PE ratio, not only are you buying a stock with stronger implied returns, but you are getting a larger dividend too.
For value investors, the PE ratio remains one of the most useful indicators there is.
This article is an extract from my latest value investing course, the Marwood Value Model, where I detail a market beating strategy that selects deep value stocks based on various financial ratios and metrics. Thanks for reading.