The P/E ratio (price-to-earnings ratio) is a measure of the price paid for a share relative to the net income or profit earned per share. This is used to determine whether a stock (or broad market) is under or over priced.
P/E ratio is a good tool for evaluating stocks but it can give false information. Legendary economist Benjamin Graham noticed some bizarre P/E behavior during the Roaring Twenties and subsequent market crash. If you evaluate the P/E ratio an economic good time, earnings are artificially inflated making stocks look overly attractive. During economic bad time, earnings will be artificially deflated again skewing the P/E ratio.
Graham collaborated with David Dodd to devise a more accurate way to calculate the market’s value, which they discussed in their 1934 classic book, Security Analysis. They attributed the illogical P/E ratios to temporary and sometimes extreme fluctuations in the business cycle. Their solution was to divide the price by the 10-year average of earnings, which we’ll call the P/E10 (or PE10).
The PE10 is increasingly becoming a common method for value investors to determine whether the broader market is cheap or expensive. Not only does this method have a logical appeal to it, but data suggests that the magnitude of the market’s subsequent 10-year returns is related to its PE10 level.
P/E10 smoothes out the effect of economic downturns and upturns by averaging out 10 years of earnings. In recent years, Yale professor Robert Shiller, the author of Irrational Exuberance, has reintroduced the PE10 to a wider audience of investors.
The plot above shows PE10 as a predictor of twenty-year returns based upon the plot by Robert Shiller. The horizontal axis shows the PE10 ratio of the S&P Composite Stock Price Index. The vertical axis shows the geometric average real annual return on investing in the S&P Composite Stock Price Index, reinvesting dividends, and selling twenty years later.
This plot shows an inverse relationship between PE10 and return on investment. The higher the PE10, the lower the return on investment. The lower the PE10, the higher the return on investment. The plot shows that investors who bought when the price was relatively low relative to earnings (PE10 was low) did very well (had a high return on their investments). It suggests that investors should lower their exposure to the stock market when the PE10 is high and get into the market when it is low.
The historic PE10 average is 16.3. Hence, if the PE10 number is 14 then stocks are a good buy. If the PE10 is below 10, stocks are at an excellent price. Conversely, when the PE10 is above 20, there is a risk that long term returns on investment will be low.
PE10 of the S&P500 (with S&P500 at 1100) is about 20.