What the Price/Earnings Ratio Can Tell 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 profitability.
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, drug-maker Merck's (ticker: MRK) operating earnings over the past four quarters (through June 30, 2010) were $4.46 per share. At its current price of about $35 per share, it has a P/E of 7.8 ($35 divided by $4.46). Stated another way, investors are willing to pay $7.80 for every $1.00 of MRK 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 Merck's history and take into account the P/E range that MRK shares have traded at in the past. Fortunately, in the Internet age, that's reasonably easy to determine. By calling up a chart of MRK on www.MarketWatch.com and setting the lower indicator to show the "PE Ratio," I can observe that Merck's P/E over the past decade has tended to fluctuate between 10-20 for the most part.
When the stock moved up strongly during 2006-2007, Merck far outpaced the rate of growth of its underlying earnings. As a result, its P/E rose into the mid-to-high 20s. In other words, whereas investors had typically been willing to pay $10-$20 for each $1 in MRK earnings, they raised the ante to $25+ in 2007.
For anyone concerned about the risk associated with overvaluation, this would have been a clear warning sign. When the economy faltered in 2008, Merck was vulnerable. During the recent bear market, the stock retreated about 65% from its peak to the low.
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 MRK when its P/E returned to its normal range below 20. They don't want to pay the normal price. They want a bargain.
Let's say they would be interested in buying MRK shares if the P/E dropped below 10. There's no guarantee it would, of course. But if it got that low, they'd take a closer look. An investor purchasing MRK's shares at that point would be getting a considerable discount compared to how the market typically valued Merck's earnings.
(Of course, there's still risk involved. It's possible that a fundamental change in the company's prospects, say due to its acquisition last year of Schering-Plough or the passing of the health-care legislation, would result in Merck's sporting a permanently lower P/E. Assessing the possibility of this is another part of the buy-or-not-buy decision.)
As MRK's stock price continued to fall, so did its P/E. In February 2009, it slipped to 9.0 (price around $30 at the time). Anyone buying Merck's at that point would have eventually been rewarded — although not without having their patience tested. MRK continued drifting down, and traded as low as $20 over the next month. The P/E hit a low just above 6.2 before beginning to move up again.
Beginning in March 2009, Merck's stock price began a steady upward course, hitting a high above $41 in January 2010 before falling back into the mid-30s.
Right now, Merck's P/E, as mentioned earlier, is around 7.8. When we first gave you that current P/E number, you had no context to put it in. Now you know that a P/E in the 7-8 range is below the norm for MRK. From that, 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 16.3.
As this is being written (in late-August), the S&P 500 stands at 1060. The reported earnings for the past four quarters for the companies that make up the index is $67.20. Thus, the S&P's P/E currently stands at 15.8, just under its historical norm. By this measure, it would seem that blue chip stocks as a whole, generally speaking, are slightly undervalued right now.
One way to assess the current level of risk is to study the results from buying at this level in the past. In Table A below we've summarized what has happened over the past 75 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 10 was 13.4%. As you can see, the average gains dwindle as the P/E rises, that is, as investors paid ever higher prices for $1 in earnings — the odds have been very much against investors who buy when the P/E is above 20.
Although the level of the market's P/E is a useful guide to value, it's definitely not a perfect market-timing indicator. The "average" results shown for the entire 75-year period show us the tendency over time for value to be rewarded, but unfortunately tell us relatively little about what we can expect when investing for any single one-year period. That's because investors routinely make irrational decisions and go to extremes in the short-term, which leads to "abnormal" results.
The other columns in the table give more detail as to the broad range of one-year results. You can see that 22% of the time, careful shoppers who bought at low P/Es under 10 still lost money over the following 12-month period. And while investors who paid top dollar lost money 47% of the time, they still managed to make double-digit returns in 30% of the periods tested.
Now back to the question raised earlier: With the P/E of the S&P 500 index now at 15.8, how much risk is there, generally speaking, in buying blue chip stocks now?
According to Table A, it appears that the odds are on your side. When buying with the P/E between 13 and 17 over the past 75 years, investors have made money — or at worst broken even — 67% of the time, and lost money just 33% of the time. More than five times out of ten the gains were 10% or more. And, because this study is based on the S&P 500 index (as opposed to an index fund), dividends are not reflected, so the actual results would have been even better than shown.
This doesn't say you should or shouldn't buy now. It merely puts the current level of market risk into a historical perspective, which would have been helpful back in 1999-2000 when the market was extremely overvalued.
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 Merck's stock what the company's earnings over the past year. That's ancient history. They want to know what Merck's profits are likely to be over the 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 in a subsequent article.
September 15, 2010
© Sound Mind Investing
Published since 1990, Sound Mind Investing is America's best-selling financial newsletter written from a biblical perspective. 
Originally published September 14, 2010.
