What's a P/E ratio?

Source: Capital Pixel

The story is told of  René Descartes getting a flash of brilliance as a young teenager that led to the Cartesian co-ordinate system that brought together algebra and geometry.  Young Descartes gave a visual depiction of algebraic equations by plotting points relative to an origin.  In this, he developed a concept that belongs in a broader family of concepts that compare and classify things - something that humans love to do and that is necessary for any type of analytical work.

Here's another example:  suppose one basketball player makes 79 of 112 foul shots and another made 57 of 89.  Who has the better record?  The comparative device here--the device that puts them on the same footing--is the percentage calculation.  The first player made 70.5% of his or her shots and the second player made 64 percent.  Percentages make comparisons of these types simple, and they are used almost without thinking.  Take a stroll through Costco and you'll see people with calculators figuring the per ounce cost of 2 different cans of tuna.

For investment analysts, the most widely-used comparative metric is the P/E ratio.  Ask whether stock ABC is a better value than stock XYZ and, invariably, the very first number you will get is the P/E ratio, where P is price and E is earnings.  In fact, as you read views on the likely direction of the overall market, you will frequently see references to the market P/E relative to historical P/E.

So let's back up and think about this.  Suppose I told you that stock ABC is earning $1.50 per share and stock XYZ is earning $.75 per share.  Is ABC the better value?  When you reflect on this a bit, you realize that you really can't say.  ABC may have a price of $30 and XYZ a price of $10.  The price of ABC is 3 times the price of XYZ, but its earnings are only 2 times as much.

All of this is equalized and put on a comparative basis by the P/E ratio.  For our example, ABC has a P/E ratio of 20 and XYZ 13.33.  We say that for ABC "you have to pay $20 per dollar of earnings," etc.  Thus, from this perspective, it is easy to see that ABC is more expensive, i.e., you have to pay up for a dollar of earnings for ABC.

But this is just the first step.  It may very well make sense to pay up for ABC.  It depends on its expected growth.  Studying P/Es is just the first step.  But it is a huge first step.

As you study P/Es, you quickly come to realize there are various measures.  There are P/Es based on trailing earnings (ttm stands for "trailing 12 months") and there are P/Es based on expected earnings. There are also P/Es based on normalized earnings that use adjustment techniques to get at the underlying trend.

Here, for example,  is what you get on Yahoo! Finance for Johnson & Johnson:

Source: Yahoo Finance

CLICK IMAGE TO ENLARGE   Check that the P/E ratio of 23.08 is correct by taking the price 70.45 and dividing by EPS of 3.05.

P/Es are also used to classify investment approaches.  For example, value managers focus on lower-than-average P/E stocks whereas growth managers focus on stocks that have higher P/Es whose earnings are growing faster than average. 

As mentioned above, P/Es are also used to assess the overall value of the market.  One of most popular is the Shiller P/E 10 ratio.  This measure uses 10 years of earnings adjusted for inflation.  It is used by so-called tactical asset allocators and market timers to assess entry and exit points in the U.S. stock
market.  Here is an update Shiller P/E ratio graph from gurufocus:




Homework Problems:

1. Find the P/E ratios of VZ, MON and MSFT.  Which of these stocks do you believe is the value now?  (Hint:  go to Yahoo! Finance and put in ticker symbols.)
2. According to the Shiller Price/Earnings Ratio, is now a good time to invest in U.S. stocks?

What is the Shiller P/E Ratio?

Is now a good time to invest in stocks?  This is one of the most frequently asked questions I get from potential clients.  I like it because then I can whip out my crystal ball, put on a turban and John Lennon glasses, and lower my voice to mysteriously claim "... I see the S&P 500 3 years from now at ...."  Seriously, though, there is a tool that DIYers should know about that is widely used for valuation purposes; and that is the Shiller P/E.

Bob Shiller, author of Irrational Exuberance, is credited with foreseeing the dot.com bust as well as the housing crisis.  He has been named one of the country's top 100 most influential economists.  He is one of the leading voices in the argument that markets are not efficient and uses his particular P/E construction in that argument.

We've looked at the P/E ratio as an important valuation metric before and have noted that there are various measures, including 12-month trailing earnings and expected earnings.  The Shiller P/E is based on the past 10 years earnings adjusted for inflation.  Here is a visual from gurufocus:

Notice in the graph where Shiller's P/E was prior to the dot.com crash in 2000 and the housing market crash of 2008.  In both instances, it was well above its historical mean - hence, its reputation as a valuation metric.

Today, as you can see, the Shiller P/E is 25% higher than the historical mean.  This would suggest that better opportunities for entering the market may be ahead.  Asset allocators may choose to use this tool to go to the lower bands in their targeted allocations.  Investors looking to enter the market may decide to average in, thereby expecting better entry points.

It is important to understand that this methodology assumes an inefficient market and that this inefficiency tends to dissipate over time - i.e., reversion to the mean takes place.

My assessment is that the tool is valuable at the extremes.  If it moves outside the 25% band from here,  asset allocators may in fact want to get a bit defensive and increase that defensiveness as the ratio moves further from its historical mean.  As a valuation measure, I believe it is one of the best around and would encourage anyone interested in assessing the market from a longer-term perspective to study and track this metric.  Furthermore, if you haven't read Irrational Exuberance, get a copy and read it - you'll be smarter because you did.

There is another use for Shiller's P/E that we'll take up in the future - as a guide for the safe withdrawal rate for retirees.  As always, this information is for educational purposes only.  Individuals should do their own research or consult a professional before making investment decisions.

Withdrawal Rate (Part 2)

 In the last post, we took a look at some withdrawal rates using actual data over the recent past by examining returns on a diversified portfolio.  The latest update to that data source is the  BlackRock table of asset returns.  As I've said a hundred times, this is an extremely useful resource from which all kinds of questions can be addressed.  Admittedly, it is one path we have come down; but it has been especially rocky at times and gives a bit of insight into how asset classes have performed and how various strategies would have fared.

Along these lines I, thought it would be interesting to go back and look at a retiree who retired in 2000 and decided on a 5% withdrawal rate.  Where would he stand today?  I would also like to introduce another resource that is often used in this research - the Shiller Price/Earnings (P/E) ratio.  This ratio is sometimes used to set the initial withdrawal rate.  Simply, if the ratio is high (stocks potentially overvalued on an historical basis) then, other things being equal, the retiree should start with a lower withdrawal rate (for example 4%).  If the P/E ratio is lower, then a higher initial withdrawal rate should be considered.

Here is a graph of the Shiller P/E ratio:

Source: Online Data - Robert Shiller

CLICK TO ENLARGE  The graph shows that the market P/E in 2000 suggests it was not an especially good time for the retiree to have a high withdrawal rate.  Instead of 5% or higher, the Shiller P/E suggests 4% as a more appropriate rate.  Given this caveat, let us see where the retiree who, in fact, instead chose 5% would stand today if he achieved the BlackRock diversified portfolio returns.  Again, we assume a $1.0 million portfolio starting value and a 2% inflation adjusted income taken on 1/1 of each year.

YEAR	ASSETS (1/1)	INCOME	PORTFOLIO	RETURN	ASSETS (12/31)
2000	1000000	50000	950000	0.989	939550
2001	939550	51000	888550	0.952	845900
2002	845900	52020	793880	0.902	716080
2003	716080	53060	663020	1.235	818829
2004	818829	54122	764707	1.105	845002
2005	845002	55204	789797	1.054	832447
2006	832447	56308	776139	1.13	877037
2007	877037	57434	819603	1.06	868779
2008	868779	58583	810196	0.772	625471
2009	625471	59755	565716	1.208	683385
2010	683385	60950	622435	1.13	703352
2011	703352	62169	641183	1.018	652725

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The table shows that the 77-year-old retiree would now have 65.2% of his nest egg left to draw on.  The similar exercise using a 4% withdrawal rate would have 83.6% of the nest egg still available at the end of 2011.

Again, recognizing this is one path, it still yields some valuable insights into varying withdrawal experiences, the potential value of taking into account initial conditions (i.e. the  p/e ratio), and the dynamic nature of the experience of drawing down the nest egg.

Looking back at the Shiller P/E suggests that today's retiree can consider a slightly higher withdrawal rate.  For those interested in doing further research, you may want to consider redoing the results and starting with the 5% rate but not taking an inflation adjustment when markets are down, as suggested by Jon Guyton.

Also, those interested in this research may want to review the Shiller P/E.  It is not, to say the least, your typical trailing 12 months p/e ratio.

Disclosure:  This information is for educational purposes only.  Individuals should do their own research or consult a professional before making investment decisions.