The Common Sense Investor

Price to Earnings Ratio tells you how much of a premium you are going to pay for a stock in relation to its current earnings power.

Common sense investing involves buying strong companies at reasonable prices. One way to measure for “reasonable prices” is the price-to-earnings ratio.

Price to earnings ratio (p/e ratio) is a useful metric for evaluating the attractiveness of a company’s stock price. It helps the investor determine whether a stock is overpriced, fair, or undervalued.

To understand the importance of price-to-earnings, it might help to think of buying stock like buying products at a store. You want to purchase things at fair or value prices (think “sales” ), so there is typically a range of prices that you’d be willing to pay. To use an obvious example, you’d probably never pay $500 for a gallon of milk.

The price-to-earnings ratio will help you determine a fair price for buying a company’s stock. The computation was made popular by the late Benjamin Graham who many consider as the Father of Value Investing and who has also had a huge impact on the investing methodologies of Warren Buffett. According to the Graham-Buffett method for successful investing, price-to-earnings is a key criteria for determining whether a stock is trading on an investment or speculative basis.

But what exactly is a price to earnings ratio?

In its simplest terms, a price to earnings ratio is the price an investor is paying for $1 of the company’s annual earnings. To illustrate, if a company is reporting basic or diluted earnings per share of about $5 and the company’s stock is selling at $30 per share, the p/e ratio is 6 ($30 per share divided by $5 earnings per share = 6 p/e).

(There is no need to be confused about the computations because most stock-quote systems online will be able to give you the p/e ratio automatically if you ask for a detailed quote for any company).

Once you have the p/e ratio of a certain company’s stock you can then use it to help you differentiate between a speculative (and often emotion-driven) stock that is selling high just because it is the hot pick on Wall Street, and a solid company that may have fallen out of favor and is currently selling for just a fraction of its actual worth as a profit generator.

One of the first things to understand though is that different industries possess different p/e ranges that are considered normal. Just like different crops prosper well in different climates, different industries can prosper under different price-to-earnings ratios. This is because there are different expectations for different business sectors. Technology companies may sell at an average of 40 p/e while textile companies may only trade at an 8 average. Of course, there are exceptions to this but in general these differences between sectors are quite normal.

However, there is debate as to whether the disparity between the normal p/e ratio in various industries is legitimate. There are many value investors who think that all companies, regardless of industry, should be held to the same standards. We tend to agree. Historically high price-to-earnings ratios may indicate that individual stocks, sectors or even whole markets are over-priced. When this is the case, investors put themselves at risk for long-term price correction.

One way to determine if a whole sector is being overpriced is when the average p/e ratio of all the companies in that sector is way above the historical average. The common sense investor should see historically high P/E ratios as a sign that an industry or even a single company is too expensive. Additionally, using the p/e ratio, an investor can get out of an overpriced sector or stock at a good time before it experiences large declines.

The price-to-earnings ratio gives the common sense investor a good picture of how expensive any given equity stock is. It makes very little sense to buy expensive stock because you expose yourself to market correction and high-probability volatility. Buying expensive stock is most often associated with short-term perspective and irrational exuberance. It is also indicative of a “following the crowd” mentality. Since “the crowd” drives up the price of a stock, it logically follows that buying expensive stock means buying stock after “crowd” has driven up the price.

In sum, the common sense investor should really be looking for low P/E ratios. However, having a low P/E ratio is not enough: bad companies could have low price-to-earnings ratios. You want to find good companies with low P/E ratios. The easiest way to filter out the good companies from the bad ones is to look at how they use your money. The best measurement for how companies use your money is Return on Equity.

Look for companies with a low P/E and high return on equity and you’ll be off to a wonderful start.