Price/Earnings Ratio – What’s it good for?

I mentioned to a friend the other day that the price of gas was going up. His reply was sort of funny to me. He said he didn’t pay much attention to the price of gas. He just fills up his tank. As someone who loves numbers way too much, I can’t imagine buying something without knowing the price. As a value investor, I like to know how much I’m paying when I invest in the stock market. The Price-to-Earnings ratio (or P/E) is a good place to start.

There are all sorts of ways to measure P/E. We don’t need to get into that today. All of those measures compare how much a share of stock costs compared to how much money that company is making. You can use the same measure for groups of stocks, the entire U.S. stock market, and world stock markets. A high P/E means stocks look expensive. A low P/E means stocks look cheap.

P/E ratios can give you some useful information, but it needs to be viewed the right way. A P/E ratio is actually a bad indicator of how stocks will perform over the next year. Think of U.S. stocks. Their P/Es have been high for years, but up until this year they’ve continued to have great performance year after year. I hope you didn’t sell your U.S. stocks in 2013 because they looked expensive.

What P/Es do a better job at is preparing you for returns over the next decade. The fact that U.S. stocks have high P/Es says we should be prepared for lower than average returns over the next ten years. The fact that P/Es of international stocks are lower than U.S. stocks also tells us that int’l stocks might do better than U.S. stocks over the next decade. Even that’s not guaranteed. So stay diversified between the two.

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