Made popular by the late Benjamin Graham , who was dubbed the "Father of Value Investing " as well as Warren Buffett's mentor, Graham preached the virtues of this financial ratio as one of the quickest and easiest ways to determine if a stock is trading on an investment or speculative basis , often offering some modifications and additional clarification so it had added utility when viewed in light of a company's overall growth rate and underlying earning power.
There are some significant limitations, partly due to accounting rules and partly due to the terribly inaccurate estimates most investors conjure out of thin air when guessing future growth rates. Regardless of those shortcomings, it is something you should know how to define and how to calculate by heart. This can allow you to more easily compare the return you are actually earning from the underlying company's business to other investments such as Treasury bills, bonds, and notes , certificates of deposit and money markets , real estate, and more.
As long as you do your due diligence, looking out for phenomenon such as value traps , viewing both the individual stocks you hold in your portfolio, and your portfolio as a whole, through this lens can help you avoid getting swept away in bubbles, manias, and panics. It forces you to " look through " the stock market and focus on the underlying economic reality. The great news if you are inexperienced with investing is that most financial portals and stock market research sites will automatically figure the price-to-earnings ratio for you.
Once you have the magic number, it's time you begin wielding its power. It can help you differentiate between a less-than-perfect stock that is selling at a high price because it is the latest fad among stock analysts, and a great company which may have fallen out of favor and is selling for a fraction of what it is truly worth.
There are exceptions, all things considered, these variances between sectors and industries are perfectly acceptable. They arise, in part, out of different expectations for different businesses. From time to time, the situation is turned on its head. In the aftermath of the Great Recession of , technology stocks traded at lower price-to-earnings ratios than many other types of businesses, such as consumer staples, because investors were frightened.
There is a saying in the international investing market for wealthy families that sums this sentiment and tendency up succinctly: From coffee, pasta, and baby food to ice cream, pet supplies, and beauty products, it is almost impossible for a typical member of Western Civilization to go a year without somehow, someway, directly or indirectly putting cash in Nestle's coffers, which explains one of the reasons it is one of the most successful long-term investments in existence.
Historically, this has spelled trouble. We saw the repercussions of just such gross-over pricing in the technology crash following the dot-com frenzy of the late 's and, later, in the stocks of companies linked to real estate. Investors who understood the reality of absolute valuation knew it had become a near mathematical impossibility for equities to generate satisfactory returns going forward until the excess valuation had either burned off or stock prices had collapsed to bring them back in line with fundamentals.
Men like Vanguard founder John Bogle went so far as to sell off all but a fraction of their stocks, moving the capital to fixed income investments such as bonds. Such situations tend only arise every few decades but when they do, tread carefully and make sure you know what you are doing.
A perfect illustration comes in when the stock market fell apart. Frankly, I'm not sure the inexperienced investor should pay attention to it, instead opting for a systematic, or formulaic, approach. What does this mean? This means company XYZ is much cheaper on a relative basis. Remember, just because a stock is cheap doesn't mean you should buy it. Many investors prefer the PEG Ratio , instead, because it factors in the growth rate.
Is the business losing key customers? Is it simply a case of neglect, as happens from time to time even with fantastic businesses? Is the weakness in the stock price or underlying financial performance a result of forces across the entire sector, industry, or economy, or is it caused by firm-specific bad news? Is the company going into a permanent state of decline? I prefer something called owner earnings.
Basically, I use it, adjusted for temporary accounting issues, and try to figure out what I'm paying for the core economic engine relative to my opportunity costs. Then, I construct a portfolio from the ground-up that not only contains individual components that were attractive but that, together, help me reduce risk.
Updated February 18,More...