One of the important metrics to follow in investment management is the P/E ratio. Just like a doctor does all kinds of tests to evaluate their patient such as heart beat, blood pressure, temperature, cholesterol, patient color, etc., the investor must look at many metrics to understand what is going on with an investment. The P/E would equate with the evaluation of the patient’s heart to a doctor. The heart’s performance is one of the most important metrics a doctor evaluates.
P/E is simply the price of the security divided by the earnings of the company. There are many ways to look at this important metric, but it is commonly framed as the ratio of the dollars an investor is willing to pay per dollar of earnings. There are also two major varieties of the P/E ratio – the forward P/E and trailing P/E. The forward P/E is the current price divided by the “projected” annual earnings. The trailing P/E is the current price divided by the past annual earnings.
I don’t pay much attention to the forward P/E because the “E” is the predicted earnings. Wall Street’s estimates of projected earnings varies widely in its accuracy (No one has a crystal ball!). This is why I only pay heed to the trailing P/E. Like a baseball player’s batting average, the trailing P/E is how they have batted in the past. Did you ever hear about someone talk about a batter’s forward batting average (LOL)? When they do, you can be sure the judgements vary significantly and no one is ever spot on.
When the market is rising, investors are constantly willing to pay more and more per dollar of earnings. At the top of a bull market, they pay very high P/E’s. Company earnings are rising at the same time with a robust economy. So, there are two levers that indicate what an investor is willing to pay for a security. Stock prices are rising causing higher P/E’s and company earnings are rising at the same time.
Now to the downside that investors should be watching. When the market tops out, investor enthusiasm wanes, so investors are less enthusiastic to pay higher and higher P/E’s for a security. This means the P/E ratio starts to decrease and as enthusiastic as investors are in a bull market, they become equally apathetic in a bear market. Usually, the economy is declining with the stock market (but not always), so company earnings are contracting at the same time.
Like a boxer, it is great to be the one giving the jab (increasing P/E’s) and the upper cut (increasing earnings), but being the receiver of the jab (decreasing P/E’s) and the upper cut (decreasing earnings) is very painful. This is why it’s always good for an investor to be sure that they are not paying too much for a security in a bull market. A bear market ALWAYS follows. Every sportsman has their rise and their fall. It’s inevitable. This is why it’s important to not go too far out on the edge in an up market. The fall can be serious or even fatal!
A study of history shows that P/E’s can get really high in a bull market. They can be higher than 25. But, in a bear market, they can shrink to lower than 8.
The lesson is always to protect your downside. Avoid the jab and upper cut, and live to fight another day!
