Misconceptions of the Price-to-Earnings Ratio

by Pop on September 4, 2010

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P.S.: This is a big deal for all you index fund buyers too.

The Wall Street Journal ran a story earlier this week which made the case that price-to-earnings ratios don’t matter as much anymore. It’s a seductive argument. We’re in an age where a huge number of trades are made by quants, many of whom care more about stock market momentum than “boring” and traditional measures of value.

But ultimately, it seems hard to believe that the P/E ratio would become totally irrelevant in the way the authors and analysts in the story argue.

First, a quick definition. The P/E ratio is simply a stock’s price divided by its earnings. Depending on your preference, you can use a company’s last 12 months of earnings, its future 12 months of estimated earnings, the average of past years of earnings, and on and on.

I find it easiest to think of it in terms of yield. Just as your money market account yields a certain percentage every year (probably around 1% right now), a company regularly earns a certain amount of money for every dollar you have invested. Of course, company earnings are far less certain than that of a bank account, and that’s why investors require earnings yields—which is the inverse of the P/E—to be much higher than yields on safe investments like Treasury bonds and FDIC-insured accounts.

If you crack open a book on “how to invest”, the P/E is likely to be the explained in the first or second chapter.

Before we move on, if you just tend to dollar-cost average into index funds, like most personal finance blogs (including this one) suggest, you might wonder why this discussion even matters. The thing is, the central premise of buy-and-hold investing is that stock prices always move up over long periods of time. This should happen because earnings should rise over time, as the American economy continues to advance.

However, in a world where a P/E ratio doesn’t matter, by extension, earnings don’t matter either. Traders continually try to outguess each other rather than find good companies at cheap prices. You could say that more direct measures of value, like dividend yields, might become more important, but really the two are pretty similar—with the dividend yield, you just get to keep the earnings yourself.

Sure, P/Es are going down.

The article also spent a good deal of time on why P/E ratios might drop. That’s something I do think investors should worry about in the short term.

The market’s average P/E for the last couple hundred years had been about 15. However, over shorter periods, it has spent time at much higher and lower levels. At the end of the internet boom, it actually spent time in the 40s! During times of economic stress, like the 1980s and 1930s, it has gone into the single digits.

A few things influence their direction. The most simple is interest rates. Investors demand to be compensated for the risk stocks represent. So when risk-free Treasury bond rates go up, P/Es normally drop. Right now, Treasury bond rates are at historic lows. They have only one way to go—up.

But beyond that, investors can drive P/E ratios down when they perceive stocks to be more risky or feel their growth prospects are weaker. Those are both realities that most economists think we’ll be facing for a while.

No one factor should guide your decision to buy or sell.

If P/Es drop, even as the economy and earnings continue to recover, stock prices will stay the same or even drop. Such a period recent happened in the 1960s and 1970s.

Of course it turned out that when they hit those single-digit post Depression lows, it was an excellent time to buy stocks. It just took a decade or so for that to become clear.

And that might be the best takeaway for someone wondering why they should even care that these ratios might stay low for awhile. We’re used to our stock investments generally rising from year to year. Yes, the last ten years were a “lost decade”, but we didn’t really have to feel that until the market halved in 2008 and 2009.

This time around the market’s movements might be much more frustrating. It won’t go up. It won’t go down. It will just bounce around for years.

That means that even more so than during the last ten, you’re going to need patience. Owning stocks will pay off over the long run. The long run just be a long time coming.

In the end, the P/E must matter.

When you actively trade stocks, one of the easiest things to forget is that you’re buying and selling companies, not just meaningless pieces of paper.

In the short term, those pieces of companies can vary in value by huge amounts. One day Apple will have a P/E of 15, the next it will be 50.

That becomes especially easy with companies that aren’t yet paying a dividend. When a company reinvests all of its earnings, the only way you make money is if the stock price goes up.

If you look at investors like Warren Buffett, however, who truly are in it for the longterm, a company’s earnings will always matter. Because in the longterm, any mature company should end up paying a dividend to its investors.

That’s what makes the stock market different from a Ponzi scheme, and why the P/E will always matter.


{ 7 comments… read them below or add one }

Jeff September 5, 2010 at 10:31 am

I get why P/E must matter, but I’m missing how it follows that the stock market is different from a Ponzi scheme.

Is it because you’re buying real companies that (hopefully) are producing real new value to the world, not just paying old investors with new investor money? If so, then wouldn’t that mean companies that don’t add lasting value to the economy (e.g., companies that sell toys, like iPhones, or liquor, or most consumables maybe) _are_ Ponzi schemes?

Somethin’ I’m missin’ here maybe, but I still don’t trust the market.

Pop September 7, 2010 at 12:05 am

Hey Jeff, well hopefully a company like Apple will eventually start paying out its earnings as dividends. In that way, if you buy shares of Apple now, in 20 years (or whenever it starts paying them out), your investment will start yielding cash, even if you never sell that share to another investor. In Ponzi schemes, you never get a return on your investment unless there’s another sucker to buy it from you. In the stock market, you can make money by reselling, but dividends are just as good a way to make money. Thanks for the comment.

Jeff September 10, 2010 at 12:29 pm

Plenty of Ponzi schemes have paid returns/dividends to early investors. Some early investors in Ponzi schemes even made really good returns. Still the vast majority of investors get screwed in the scheme. So I’m not sure how dividends are evidence of not being a Ponzi scheme either.

The show “American Greed” is chock full of stories of Ponzi schemes of this nature. I can pull some examples if needed.

Pop September 10, 2010 at 1:32 pm

But they paid the dividends with later investors’ money. Companies pay dividends with money they earn (or borrow, which is dumb, but that’s a whole noter story). So General Mills earns a few million dollars selling people cereal, then they give some of those millions to investors and reinvest the rest. They can’t “fake” dividends by using money people invest in General Mills stock to pay early investors, as would happen in a Ponzi scheme.

Jeff September 10, 2010 at 1:43 pm

1) So, to go back a step, any companies that don’t currently pay dividends, like Apple, are Ponzi schemes? As you said, we hope one day they will, but for now most companies don’t.

2) The aspect that continues to seem to me to be Ponzi-esque even for the dividend payers is the insider information that inevitably exists, which we, not being the insiders, don’t know about, and which thus makes any stock purchase indistinguishable from a scam, from the perspective of outsider knowledge (or lack thereof).
Perfect free markets with equal information among rational agents doesn’t exist. So why should rational folks without insider info play the market?

Pop September 10, 2010 at 7:57 pm

According to a quick screen on Morningstar, 75% of large companies do pay some earnings out to shareholders. Granted, right now a bunch don’t have earnings. It’s common for high-growth companies, like Apple, to not pay dividends, but when the growth slows down, they start. If you’re a longterm, Buffett-like investor, you buy companies in anticipation of earnings getting paid out. These are pieces of companies you’re buying, not slips of paper.

I don’t think insider information is acted on so frequently to make trading stocks a suckers game, but even accepting that, having advantaged traders doesn’t make the stock market a Ponzi scheme. If you owned your own business, would you call that a Ponzi scheme too? All stocks are are little pieces of businesses.

Rob Bennett September 13, 2010 at 3:18 pm

In Ponzi schemes, you never get a return on your investment unless there’s another sucker to buy it from you.

The way that I would say it is that the stock market is in part a Ponzi scheme and in part a collection of real income-generating businesses. The part that is a Ponzi scheme can be known by making reference to the amount by which the market is overvalued. Investors never obtain any return on the portion of their investment dollar that goes to purchase overvalued shares (this is cotton-candy nothingnesss) but only on the portion of their investment dollar that is directed to the purchase of shares of real businesses.


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