What the Price/Earnings Ratio
Tells You About Risk
Stock prices move in ways that often appear erratic and whimsical. They're affected by the world stage (global politics, trade policies, currency exchange rates) as well as domestic concerns (economic data, interest rates, tax legislation). Some might throw in sun spots and who wins the Super Bowl as well. But ultimately, stock prices are driven by expectations of profitabililty.
The measure used to describe the relationship between prices and profits is the price-to-earnings ratio, or P/E for short. It's most commonly calculated by dividing a company's price by the earnings the company has most recently reported for the past 12 months. For example, McDonald's (ticker: MCD) has reported $1.80 in per share profits over the past four quarters. At its current price of $32 per share, it has a P/E of 17.8 ($32 divided by $1.80). Stated another way, investors are willing to pay $17.80 for every $1.00 of MCD earnings. By itself, this fact doesn't tell us whether that's a reasonable price to pay.
To learn that, we need to know more about McDonald's history and take into account the P/E range that MCD shares have traded at in the past. Fortunately, in the Internet age, that's reasonably easy to determine. By calling up a chart of MCD on www.MarketWatch.com and setting the lower indicators to show the "rolling EPS" and "PE range", I can readily observe that McDonald's P/E over the past decade has tended to fluctuate between 20-30. When the stock moved up strongly during 1999, it far outpaced the rate of growth of its underlying earnings. As a result, its P/E rose into the 30-40 range. In other words, whereas investors had previously been willing to pay $20-$30 for each $1 in MCD earnings, they raised the ante to $30-$40 during the final year of the bull market. For anyone concerned about the risk associated with overvaluation, this would have been a clear warning sign. When the mania ended, McDonald's was vulnerable. During the 2000-2002 bear market, the stock retreated sharply.
A "value" investor watching the stock fall might have been looking for a low risk entry point. It wouldn't be enough for them to buy MCD when its P/E returned to its normal range in the 20s. They don't want to pay the normal price. They want a bargain. Let's say they would be interested in buying MCD shares if the P/E dropped to 15. There's no guarantee it would, of course. But if it got that low, they'd take a closer look. An investor purchasing MCD's shares at that point would be getting a considerable discount compared to how the market typically valued McDonald's earnings.
Of course, there's still risk involved. It's possible that a fundamental change in the company's prospects would result in McDonald's sporting a permanently lower P/E. Assessing the possibility of this is another part of the buy-or-not-buy decision.
As MCD's stock price continued to fall, so did its P/E. By September 2002, it dropped below 15 to 14.5 (price of $19 divided by earnings of $1.31). Anyone buying McDonald's at that point would have eventually been rewarded—although not without having their patience tested. MCD continued drifting down for the next six months, eventually bottoming out in the $12-$13 area, some 30% lower. We know, of course, that just because you buy a stock at a relatively low price, that doesn't mean it can't move lower. However, since that low in March 2003, two years ago, McDonald's has been on a steady upward course, recently hitting a high of $34. The current P/E, as explained earlier, is at 17.8. When I first told you that, you had no context to put it in. Now you know that a P/E at that level is slightly below the norm for MCD and you might conclude that the stock has more room to grow on the upside.
Analysts compute P/E ratios for stock indexes and stock funds as well as individual stocks. Since the S&P 500 index of blue chip stocks was first devised in the 1930s, its P/E has averaged about 16. However, if you look only at the past 25 years, the average is somewhat above 18, a reflection of the fact that during the strong markets of the 1980s and 90s investors were willing to pay relatively more for stocks. As this is being written in mid-March, the S&P 500 stands at 1188. The weighted earnings for the past year (updated weekly in Barron's) for the companies that make up the index is $60.97. Thus, the S&P's P/E currently stands at 19.5, slightly above its norm of the past quarter century. By this measure, it would seem that blue chip stocks as a whole, generally speaking, are somewhat overvalued right now. If you buy them now, how much risk are you taking?
One way to assess that is to study the results from buying at this level in the past. In the table below I've summarized what has happened over the past 25 years when the S&P 500 index was bought at various P/E levels and held for one year. For instance, the average annual gain from buying the index when its P/E was less than 20 was 16.4%. As you can see, the gains dwindle and then disappear altogether as the P/E rises, that is, as investors paid ever higher prices for $1 in earnings. The 6.7% average return from buying when the P/E was in the 20-28 range may look okay at first glance, but keep in mind that the average annual rate of growth for the S&P 500 index for the entire 25-year period was a little over 11%. Thus, the 6.7% was considerably below average during the period. And, as you can see, the odds are very much against investors who buy when the P/E is above 28.
Of course, because investors routinely make irrational decisions, the markets are essentially unpredictable. Thus, although the level of the market's P/E is a good guide to value, it's not a perfect market timing indicator. The other columns in the table give more detail as to the range of results. You can see that 13% of the time, careful shoppers who bought at low P/Es still lost money over the one year period. And while investors who paid top dollar lost money 53% of the time, they still managed to make excellent returns in 12% of the periods tested.
Now back to the question raised earlier: With the P/E of the S&P 500 index now at 19.5, slightly above its norm, how much risk is there, generally speaking, in buying blue chip stocks now? According to the table, it appears that the risk is a small one. In the past 25 years, investors have made one-year gains of 10% or more 72% of the time and lost money only 13% of the time when buying with the P/E under 20 as it is now. This doesn't say you should or shouldn't buy now. It merely puts the current level of market risk into a historical perspective, a handy thing to have had in 1999-2000.
There is, however, a problem we haven't addressed. If earnings are what investors are paying for, then our view of them should be forward looking, not backward. In other words, it really doesn't matter to a potential investor of McDonald's stock what the company's earnings were last year. That's ancient history. They want to know what McDonald's profits are likely to be next year, and the next, and the next. That's where Wall Street analysts and their earnings forecasts come into the picture. We'll take that subject up next month as we build a P/E ratio based on "forward" earnings rather than trailing ones. 
- Understanding the P/E ratio | Investopedia.com
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