It’s been a while since I’ve had an education-themed post, so today I want to take a look at one of the most basic valuation metrics: the price-to-earnings ratio.

Investors use the price-to-earnings ratio, or the P/E ratio, to determine how much investors are willing to pay per dollar of earnings.  So when I say a company is currently trading at 20 times earnings or has a multiple of 20, the interpretation is that an investor is willing to pay $20 for $1 of current earnings.

In general, a high P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E.  Historically, stocks with lower P/E ratios outperform those with higher P/E ratios in the long term.  A study done by Michael Zhuang confirms this. 

Mr. Zhaung took 50 years of stock market data (1958-2007) and for each year separated stocks into three portfolios: the top 30% P/E portfolio, the middle 40% P/E portfolio, and the bottom 30% portfolio.  Mr. Zhaung’s data showed that if you invested $1 in each of the three portfolios at the beginning of 1958, then you would have the following returns 50 years later:

- Top 30% P/E portfolio = $91

- Middle 40% P/E portfolio = $322

- Bottom 30% P/E portfolio = $1,698

The results also showed that there was not a single decade, in the past 50 years, in which the bottom 30% P/E portfolio did not outperform the top 30% P/E portfolio.  However, this does not mean that low P/E stocks outperform every year.  In 2007, for example, the top 30% P/E portfolio outperformed the bottom 30% portfolio by more than 13%.

It’s safe to say that the P/E ratio is a very useful valuation measure for long-term stock investment, but like many other valuation measures, it shouldn’t be used without comparisons.  A company’s P/E ratio is more useful when compared with other companies in the same industry, to the market, or against the company’s own historical P/E.  Look at the table below:

We don’t gain much out of knowing that CSCO has a higher P/E ratio than LMT because the two companies are in completely different businesses with different growth potential. 

We can see, however, that the Aerospace & Defense industry is cheaper than the broader S&P 500, which indicates there is value in this industry.  Even more, we see that LMT and GD re cheap relative to its industry peers (represented by the Aerospace & Defense index).  We can also tell that LMT and GD are trading below their 5-year average P/E, which also suggests they are a bargain.

Comparing the technology sector to the S&P 500 tells us that the sector has is similarly valued – not too cheap, not too expensive.  When comparing CSCO’s P/E to the S&P 500, the technology sector, and its historical P/E, we can assume that CSCO is fairly valued.  On the other hand, the above data shows HPQ might represent a good value at this point in time. 

It’s important to remember that P/E ratios of companies in very stable, mature industries typically have lower P/E ratios than companies in relatively young, fast-growing industrials with more robust future potential.  This applies very well to the above example.

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Peter Lazaroff, Investment Analyst