If you were to ask somebody how expensive or cheap a certain stock or the whole market is, they would probably tell you what its price/earnings (p/e) ratio is. I frequently write about valuations based on this legendary ratio. Even people who aren’t too familiar with the stock market have heard of it. The big question naturally becomes “is it useful?”
Ubiquitous
Before getting into the intrinsic usefulness of the p/e ratio, I want to mention that it is useful simply because so many people know of it and trade based upon it. This is a similar defense of technical analysis that I often make. As a trader or an investor, you need to know what tools are being used by other market participants.
As with many financial topics, volumes of academic material can be devoted to the p/e ratio, so I will go over the main points you need to know about it. I believe the p/e ratio is still relevant today and always will be for several reasons. First of all, earnings will always be the main driver of investment values. Earnings as opposed to sales or page views will always be what truly matters since that is what the owners of a business take home.
The p/e ratio is a great tool to compare valuations across industries. Each industry has their own dynamics and one needs a metric that can compare apples to apples. For example, cyclical stock might have a p/e ratio of 20x and a biotechnology stock might have a p/e of 18x. It might be the case that the former is much cheaper than the latter because it is cheap compared to other stocks in the industry, rather than versus the biotech stock.
There are detractors of the ratio that claim that earnings can be manipulated and that it is irrelevant for firms with negative earnings. There is some truth to this, but I would mention that no single metric is a silver bullet with all of the answers. It is best used in conjunction with many other factors.
Still Relevant
Academics have studied the p/e ratio and have found that stocks that are cheaper based on this metric do outperform their more expensive brethren over time. Of course this might not always be the case, but I think that it will hold as long as there is a stock market. This is one of the main reasons why I believe it is still relevant today. Finding cheap stocks with great fundamentals in great industries will always be a winning recipe to generate strong returns.
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