Fundamental Analysis and Position Trading: Evolution of a Trader

CHAPTER 8

Price-to-Earnings Ratio

The price-to-earnings (P/E) ratio is perhaps the most well-known of the financial ratios. If you were to ask anyone walking down a city street what the P/E ratio was, they might say that the nearest store has a bathroom. Those knowing something about finances might even be able to describe the ratio.

The price-to-earnings ratio is the current stock's price divided by a year's worth of earnings. If your crystal ball is especially good, you may want to divide price by future earnings. In one of their P/E numbers, for example, Value Line uses a blend of six months' worth of estimates and six months of reported earnings. However, they base their “Average Annual P/E ratio” on 12 months of actual earnings and the average yearly price. I used their average annual P/E ratio in the studies that follow.

• The price-to-earnings ratio is the current stock's price divided by a year's worth of earnings.

HISTORY LESSON

I learned about P/E ratios in 1979, but people argued about them long before that. According to several sources, S. Francis Nicholson (1960) was an early and significant contributor describing how a low P/E strategy outperformed stocks with high P/Es.

People believed that P/E ratios were a quality measure, that the higher the ratio, the higher the quality of the stock and the higher its price. However, a rising stock price often got ahead of earnings, inflating the ratio and making it soar like a hydrogen balloon. One lightning strike and, well, ...