“Most of the time common stocks are subject to irrational and excessive price fluctuations in both directions as the consequence of the ingrained tendency of most people to speculate or gamble... to give way to hope, fear and greed."
--- Benjamin Graham, Investor and Author.
A market indicator that was in vogue for a century but has lost a lot of appeal over the last couple of decades is the price per earnings (P/E) ratio. It’s calculated by simply dividing the price of a stock by it’s earnings. Seems simple enough but any discussion of P/E ratios quickly leads to which earnings? Last years or next years? The market has found a replacement for this indicator in the PEG ratio, which is simply the P/E ratio divided by the stock’s growth rate. This new indicator now compares the company’s P/E ratio to it ability to grow those earnings. It’s a nice twist and it actually puts meaning to a company’s P/E ratio.
Here’s the result of the change. If a stock’s P/E ratio is higher than its growth rate, it’s PEG is greater than 1.0 and is considered over priced in relation to its expected future growth prospects. If a stock's P/E is lower than it's growth rate, the PEG is less than 1.0 and is considered underpriced for its expected future growth prospects. This new indicator individualizes P/E ratios for each and every individual company. It was a truly amazing improvement of an old indicator.
This is all well an good but the P/E ratio of the entire stock market has been recorded for well over 100 years so there’s plenty of historical information going back through all those periods of war and peace, expansion and depression. As can be seen in the chart, the overall market’s P/E ratio has spent the majority of it’s time between 10 and 20. Periods outside this range quickly fell back into the range. On this past Friday, 25 Oct 2013, the P/E ratio of the DOW Industrials is 17.42 and the S&P 500 is 18.63. I use this information as a check to let me know from an overall market perspective if the market is overbought or oversold and whether I should be putting new money into the market. It gives me that strategic perspective or outlook I need to evaluate the overall health of the market.
For researching individual stocks, as opposed to the overall market, the PEG ratio is probably more appropriate. I always check that ratio first when I’m looking at the fundamentals of a company. But in the back of my mind I still have that old idea that if a company’s P/E ratio is over 20 (regardless of its PEG ratio) it’s telling me that the company may be overpriced at this level. This is especially true for larger, established companies like those found on the list of Dividend Aristocrats. If a Dividend Aristocrat has a P/E above 20 I tend to withhold any attempts to accumulate additional stock unless there’s a convincing argument being made by its other fundamentals or its chart.
Here’s the result of the change. If a stock’s P/E ratio is higher than its growth rate, it’s PEG is greater than 1.0 and is considered over priced in relation to its expected future growth prospects. If a stock's P/E is lower than it's growth rate, the PEG is less than 1.0 and is considered underpriced for its expected future growth prospects. This new indicator individualizes P/E ratios for each and every individual company. It was a truly amazing improvement of an old indicator.
This is all well an good but the P/E ratio of the entire stock market has been recorded for well over 100 years so there’s plenty of historical information going back through all those periods of war and peace, expansion and depression. As can be seen in the chart, the overall market’s P/E ratio has spent the majority of it’s time between 10 and 20. Periods outside this range quickly fell back into the range. On this past Friday, 25 Oct 2013, the P/E ratio of the DOW Industrials is 17.42 and the S&P 500 is 18.63. I use this information as a check to let me know from an overall market perspective if the market is overbought or oversold and whether I should be putting new money into the market. It gives me that strategic perspective or outlook I need to evaluate the overall health of the market.
For researching individual stocks, as opposed to the overall market, the PEG ratio is probably more appropriate. I always check that ratio first when I’m looking at the fundamentals of a company. But in the back of my mind I still have that old idea that if a company’s P/E ratio is over 20 (regardless of its PEG ratio) it’s telling me that the company may be overpriced at this level. This is especially true for larger, established companies like those found on the list of Dividend Aristocrats. If a Dividend Aristocrat has a P/E above 20 I tend to withhold any attempts to accumulate additional stock unless there’s a convincing argument being made by its other fundamentals or its chart.
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