Defining Price/earnings ratio
The price to earnings ratio (P/E) is the relationship that the price of a share bears with its earnings per share (EPS), patient either current or potential. The formula is:
For example, if a share is selling at $10 and is currently earning 50 cents per share, the P/E ratio for that share is
The P/E Ratio is often used to calculate the value of a share but is a subjective test. Some people could consider a P/E ratio of 18, for example, too high; others would think it was just right.
What Benjamin Graham thought about P/E ratios
Benjamin Graham looked at P/E ratios as a measure of stock market performance and calculated average ratios for the periods 1871-1970. The lowest average in that period was 9.5 (1941-50) and the highest was 18.1 (1961-63). Graham compared these calculations to the rates available on high-class bonds. (A P/E ratio of 20 implies an earnings yield of 5%).
Most analysts concentrate on the current or prospective P/E of a share. Benjamin Graham, more wary and always conscious of the margin of error factor, preferred to look at average earnings.
In Security Analysis, Graham said this:
This does not mean that all common stocks with the same average earnings should have the same value. The common-stock investor (ie the conservative buyer) will properly accord a more liberal valuation to those which have current earnings above the average, or which may reasonably be considered to possess better than average prospects.
But it is of the essence of our viewpoint that some moderate upper limit must in every case be placed on the multiplier in order to stay within the bounds of conservative valuation.
We would suggest that about sixteen times average earnings is as high a price as can be paid in an investment purchase in common stock.
In setting out investment rules for defensive investors, Benjamin Graham identified, as a one of several benchmarks, a current price of not more than 15-16 times average earnings over the past three years. He was prepared to increase this where shares were selling at less than book value. That aside, Graham considered anything above 16 to be speculative.
What Warren Buffett thinks about P/E Ratios
Warren Buffett has not had a lot to say about P/E Ratios as a method of valuation and it is probably only one factor that he takes into account. However, most of the key stock purchases of Warren Buffett identified by Mary Buffett and David Clarke had a fairly low P/E Ratio at the time of purchase. This seems common sense if only for the ‘margin of safety’ factor. A stock with a P/E of 30 obviously has much greater scope for a fall than one with a P/E of 9.