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The Decline of the P/E Ratio?

By JLP | August 31, 2010

I just read an interesting WSJ piece on the decline in the importance of the price/earnings ratio. P/E ratios are on the decline:

The stock market’s average price/earnings ratio, meanwhile, is in free fall, having plunged about 36% during the past year, the largest 12-month decline since 2003. It now stands at about 14.9, compared with 23.1 last September, based on trailing 12-month earnings results. Based on profit expectations over the next 12 months, the P/E ratio has fallen to 12.2 from about 14.5 in May.

What does that mean?

For those of you who would prefer a little background information, a P/E ratio is simply a stock’s price divided by its earnings per share. If a stock trades for $25 per share and has $1.00 per share in earnings, its P/E ratio is 25. Another way to look at it is an investor is willing to pay $25 for each $1 of earnings. Another way to look at it is to look at the inverse of the P/E ratio, which is the earnings yield. The inverse of 25 is 4% (1/25 = .04 or 4%). So, with earnings of $1 per share and a share price of $25, this stock has a earnings yield of 4%.

Is a 4% yield good or bad? It depends. It depends on the economic outlook. It also depends on the type of company. A fast-growing company with a P/E of 25 is much different than a slow-growing company with a P/E of 25. One may represent an opporuntity when the other screams overvalued.

Back to the article…

This article claims that the P/E ratio is losing its value as a valuation measure. Why? Uncertainty. When the future’s uncertain, people aren’t willing to pay as much for future earnings. A company with a low P/E ratio means nothing if future earnings are expected to grow slowly or decline further.

P/E ratios often shrink in size and significance during periods of uncertainty as investors focus on broader economic themes.

P/E ratios fell sharply during the Depression of the 1930s and again after World War II, bottoming at 5.90 in 1949. They plunged again during the 1970s, touching 6.97 in 1974 and 6.68 in 1980. During those periods, global events sometimes took precedence over company-specific valuation considerations in the minds of investors.

What the article did not mention is that those time periods were excellent times to buy stocks. It would have also been an excellent time to dollar-cost average into stocks as a way to spread out the risk. Although this can be a bad thing in the interim, it could be a buying opportunity over the long run.

Topics: Investing | 4 Comments »


4 Responses to “The Decline of the P/E Ratio?”

  1. Jonathan Says:
    August 31st, 2010 at 6:22 am

    Every single time the P/E ratio has been ignored by investors as a whole during the past 100 years, there has been a correction in the form a bull or bear market.

    There’s a great writeup on this very phenomenon in John Bogle’s book called “Common Sense Investing”:

    http://www.amazon.com/Little-Book-Common-Sense-Investing/dp/0470102101

  2. The Biz of Life Says:
    August 31st, 2010 at 7:11 am

    This is one of those ignore it at your own peril kind of measurements. P/E is critically important in determining what is priced reasonably and what isn’t. I also like earnings yield as a relative measurement to compare bond to stocks, or stocks to stocks. Price to free cash flow is another critical measurement.

  3. BG Says:
    August 31st, 2010 at 8:50 am

    P/E ratios don’t mean much during a recession. What is the P/E ratio of a company with no earnings (or even losses): infinity!

    The trick then becomes trying to predict the ‘future earnings’ of a company to calculate the forward-looking P/E ratio. Good luck with that gamble.

    Anyhow, if the broad S&P 500 P/E ratio is significantly below normal/average, it is usually a signal to buy (and sell when it is really high).

  4. JLP Says:
    August 31st, 2010 at 8:57 am

    I agree, BG. That was the point of the article: P/E ratios are low because investors have little faith in future earnings. a stock with a P/E of 8 isn’t a good deal if future earnings decline.

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