By JLP | December 18, 2006
I’m currently reading Ken Fisher’s The Only Three Questions That Count – Investing by Knowing What Others Don’t. I’m only on Chapter 1, but have come across something I want to share with you about Price-Earnings Ratios (better known as the P/E Ratio). According to Fisher, P/E ratios are not a very good indicator of where the market is headed. To come to this conclusion, Fisher analyzed 134 year’s worth of P/E ratios and market performance. He found:
When you note the P/E ratios for the past 134 years along with the subsequent market return, some empirical truths emerge. Most startling? Most double-digit calendar-year stock market diclines – the monster drops everyone fears – occurred when P/Es were below 20, not when they were very high. Most were acutally when the P/E was below average. In the past 134 years, there were 19 times the market’s total return was negative more than 10 percent. Theirteen times – 68% of those most negative years – were on the middle to low end of the P/E range, 16.5 being the middle of the bell curve.
NOTE: It is important to note that of the 134 years, only 17 of them had P/E ratios above 20. So, it shouldn’t be surprising that most of the market’s big drops came when the P/E was below 20.
Before I go much further, I want to make sure we understand what a P/E Ratio is.
What is a P/E Ratio?
A P/E Ratio is a stock’s price per share divided by the earnings per share. So, if a stock is trading for $75 per share and it earned $3.50 per share, its P/E Ratio is 21.4 (75 ÷ 3.5 = 21.428571). This tells us that for this stock, we are paying $21.43 for each $1 of earnings. So, is a P/E ratio of 21.43 too high for this stock or too low? Good question! A lot of it depends on what kind of company this is and what industry it is in. In other words, you can’t just look at a P/E of 21.43 and say that this stock is overvalued. This is the point that Fisher makes in chapter 1 of his book.
Another way to look at the P/E Ratio
The earnings yield is simply the P/E Ratio turned upside down. To get the earnings yield, you simply divide the per share earnings by the price per share (Earnings Yield = E/P). Or, you can simply take the reciprocal of the P/E Ratio to get the earnings yield. The earnings yield makes it easier to compare a stock’s valuation with the yield you can recieve on fixed income investments. Now keep in mind that we still don’t have an apples-to-apples comparison because earnings can change on a whim (aren’t guaranteed), while government bonds are backed by the United States government. Also, there are both current earnings and forward-looking earnings. Current earnings are no guarantee of future earnings and forward-looking earnings are based on anayst’s estimates, which we all know are seldom accurate.
NOTE: Don’t confuse the earnings yield with the dividend yield, which is the dividends per share divided by the price-per-share. Dividends represent earnings that are coming back to you (as long as the company can afford to pay them).
Back to our example
In the example used above, we found the P/E for the stock to be 21.43. Taking the reciprocal (also called the inverse) of 21.43, we get an earnings yield of 4.67% (1 ÷ 21.43 = .046664). Now we can more easily compare the relative attractiveness of stocks to bonds and money market accounts, keeping in mind the risks involved with stocks. Of course, this isn’t the only thing to keep in mind when investing, but it can be a helpful tool.