Just finishing up Equity and it says a high P/E is bad because that means it’s priced high compared to earnings. Makes sense. However, when you calc intrinsic value of a company you multiply EPS by P/E, so wouldn’t a high P/E be a good thing?
You can’t use P/E on an absolute basis. If a company’s P/E is 500, does it necessarily mean it is priced high compared to earnings? You cant take it in isolation. If the industry average P/E is say, 600, then obviously you are comparatively undervalued. The bottomline is when you are using P/E you have got to compare it with the P/E of some benchmark
Great question JP. I think one should realize that in practice, P/E doesn’t necessarily correspond with intrinsic value of a company as calculated by the models we’ve been learning. P/E numbers have regressed in time series analysis, and it tends to show mean reversion over the long-term. So value investors might compare current P/E to a mean reversion level to gauge whether expectations are too high or low in the business cycle (holding future earnings constant, a higher P/E gives a higher valuation to a company.) Another way to think of it is the reciprocal of P/E is earnings yield which gives you a picture of what you can expect to gain on your investment through retained earnings in the future. A P/E of 20 means an earnings yield of 5%, which has been low compared to stock market returns in the long-term. http://www0.gsb.columbia.edu/students/organizations/cima/files/CIMA_2009_montier_presentation.pdf Check out slide 5, as you can see a general mean reversion over a long period of time. However, the usefulness of this information is highly debated. That being said, I don’t buy the value investing method of putting a lot of weight on buying P/E companies, which Peter Lynch talks about in One Up on Wall Street. P/E can be high if growth expectations are high or there is some hidden value. Also, earnings as we all know, is an easily manipulated number. Therefore, more investigation has to be done. Another thing that comes to mind is that low P/E stocks may be justified because of problems like poor management or an unprofitable business. Low P/E stocks “appear” cheap, but expectations could be low for a legitimate reason. There is also a study of P/E numbers by Ken Fisher in"The Only Three Questions That Count." In that book, he argued that when analyzing historical data, it can’t be proved that buying low P/E stocks outperforms indices over the long-term. I’d argue, however, that his analysis was a little short-sighted as he only looked a returns couple years after high P/E years (which subsequently, like during the tech bubble) Edit: Also don’t forget that different companies within a market have different P/E averages. Solar companies are on the high side, oil companies are on the low side.
JP_RL_CFA Wrote: ------------------------------------------------------- > Just finishing up Equity and it says a high P/E is > bad because that means it’s priced high compared > to earnings. Makes sense. However, when you calc > intrinsic value of a company you multiply EPS by > P/E, so wouldn’t a high P/E be a good thing? That depends if you’re buying or selling
Thanks for the input guys, it was very very informative
Ali you meant slide 6, right?
Yeah, slide 6, but 5 on the presentation