The Essential P/E. Keith Anderson
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Center for Behavioral Finance
DePaul University
Chicago, Illinois
U.S.A.
1 There are some noteworthy exceptions. John Burr Williams argued in The Theory of Investment Value that security prices are based “too much on current earning power, too little on long-run dividend paying power” (1938, p. 19). Also with the boom of the 1920s and the later crash in mind, John Maynard Keynes noted in The General Theory that “day-to-day fluctuations in the profits of existing investments, which are obviously of an ephemeral and non-significant character, tend to have an altogether excessive, and even an absurd, influence on the market” (1936, pp. 153-154). Even earlier, William Stanley Jevons said that “as a general rule, it is foolish to do just what other people are doing, because there are almost sure to be too many people doing the same thing.” [return to text]
Preface
Who is this book for?
The book is primarily aimed at investors who already know something about investing in shares, but is also suitable for market professionals and academics. Quite simply, readers should already know what a price–earnings ratio (P/E) is.
If you are a private investor, rest assured that the book assumes no prior knowledge of any particular accounting or finance terms. Everything covered is defined at the time. For more detail, many terms, in particular accounting terms, are explained in the Glossary at the back. There are however many new ideas presented, and beyond Part I even seasoned stock market investors will need to think hard.
The book is also suitable for investment analysts, fund managers or finance academics. If you have a finance MSc or MBA then you may find some of the explanations over-simplified, but you will also learn much that is new. Using the P/E to get the best investment results is far from a simple task once you get into the details, and you should also find much of interest here.
What does the book cover?
The book starts with the basics: the fundamentals of share prices and how earnings and P/Es are calculated in the UK. I then look at the value premium, which is the whole basis of using the P/E as an investment tool: low P/E shares, on average, outperform the market. I cover some of the models that believers in efficient markets have come up with to try to explain this inconvenient fact, and why those who believe in pervasive mispricing remain unconvinced. This group of value investors includes such illustrious figures as Warren Buffett – as well as your author.
The second half of the book gets into the details of the P/E: developments that have tried to improve it, and how some famous value investors have combined it with other measures. The P/E can be made into a powerful tool. But as with most powerful tools it can run amok if you don’t control it properly, check what it is telling you by looking at other statistics, and apply a liberal amount of common sense.
Structure of the book
Part I introduces the surprisingly short history of the P/E. Then, for the benefit of the majority of readers who have not done an MSc in Investment Analysis, I go through in detail how earnings and then P/Es are calculated. I use motor manual publisher Haynes as the practical example throughout the book. They are small enough to have reasonably straightforward accounts yet most readers should have heard of them.
Part II covers the value premium and some famous investors who use it. I also look at efficient market theorists’ models of how returns on stocks can be explained, some of the objections to them, and the half-way house of the popular Fama and French three-factor model.
Part III looks at some existing developments of the P/E such as the PEG ratio. I then go on to some of my PhD thesis work, since published as peer-reviewed academic papers and expanded and updated for this book. The P/E can be made into a much more powerful weapon in any investor’s armoury by applying a few relatively simple adjustments. However, the flawed results from the Naked P/E show the importance of taking into account other statistics beyond the P/E.
This is demonstrated in Part IV, where I cover two famous value investors and how they have put the P/E to work with other statistics, so as to identify value shares of reliable companies. The last chapter is some more original work, showing how you can combine the P/E with an as yet little known measure of a company’s financial stability to get outstanding and reliable investment results.
Acknowledgements
I would like to thank Richard Beddard for the huge contribution he made to earlier drafts of this book, and Stephen Eckett and Suzanne Anderson at Harriman House for the original suggestion, their support and patience. Thanks also to Werner DeBondt for agreeing to write the foreword. Along with Ben Graham’s The Intelligent Investor and David Dreman’s books, his 1985 paper with Richard Thaler Does the Stock Market Overreact? convinced me early on that misvaluation can be rife, even in a mostly efficient market.
Introduction
Who needs a book on the P/E?
In recent decades the P/E has been the most important and best-known investment ratio. Indeed, apart from the share price, it is the only investment statistic that is published in print every day. Every share quoted in London has its P/E printed daily in the Companies section of the Financial Times. The P/E also has a strong intuitive meaning: it tells you how many years’ worth of future earnings you are paying in order to buy the share now.
One might ask why there hasn’t been a book before on the P/E.
On the other hand, if you are a fund manager, the P/E or something based on it will be just one of the battery of ratios you use. You will have a filter of many different investment ratios that all of your investment universe must pass. The computer does the filtering for you, and presents you with a list of all the stocks that are interesting enough to be worth investigating further. The P/E is an integral but probably minor part of that process, and you would no more expect a book on the P/E than on ROCE or EBITDA.
While the value to investors of being familiar with this widely used statistic is clear, professionals in financial markets may find it a more surprising subject, possibly never having stopped to think how or why it is calculated that way. Such professionals may well be surprised by how easily the P/E could be improved if things were done slightly differently.
What’s interesting about the P/E?
How many years of future earnings you are willing to pay to own a company’s shares now.
What more is there to tell?
I first became interested in investing my own money in the stock market over ten years ago. Bored by a comfortable but limited existence at Deutsche Bank, I took a year out to do an MSc in Investment Analysis. While I was looking round for a dissertation topic I read Graham and Dodd’s 1934 classic Security Analysis. One of their suggestions was that you should not judge a company’s earnings potential over just the last year, but take a longer term view of 7-10 years to allow for fluctuations in the economy as a whole. This seemed such a common-sense suggestion, and yet after searching through dozens of academic papers, as far as I could tell no-one had thought to test Graham and Dodd’s assertion in the 70 years since. Being a new idea to the academic world the idea took a bit of explaining to my supervisor, but the results from the limited tests I was then able to do were promising.
Since then I have gone on to do a PhD in how to improve the P/E ratio as a predictor of investor returns, some of which is updated and summarised here.
The long-term P/E and decomposing the P/E are, I feel, surprisingly rich and complex stories. I have also taught much of this book’s contents to some thousands of undergraduate and Masters students at Durham University