In his book ‘The Signal and the Noise’, Nate Silver introduces the concept of price to earnings ratio.
Throughout the following passage, Nate references Robert Shiller‘s work plotting the average P/E ratio of S&P 500 companies between 1871 and 2012. This work was published in Shiller’s book ‘Irrational Exuberance’.
“In theory, the value of a stock is a prediction of a company’s future earnings and dividends. Although earnings may be hard to predict, you can look at what a company has made in the recent past (…) and compare it with the value of the stock. This calculation—known as the P/E or price-to earnings ratio—has gravitated toward a value of about 15 over the long run, meaning that the market price per share is generally about fifteen times larger than a company’s annual profits.
There are exceptions in individual stocks, and sometimes they are justified. A company in an emerging industry (say, Facebook) might reasonably expect to make more in future years than in past ones. It therefore deserves a higher P/E ratio than a company in a declining industry (say, Blockbuster Video). Shiller, however, looked at the P/E ratio averaged across all companies in the S&P 500. In theory, over this broad average of businesses, the high P/E ratios for companies in emerging industries should be balanced out by those in declining ones and the market P/E ratio should be fairly constant across time.
But Shiller found that this had not been the case. At various times, the P/E ratio for all companies in the S&P 500 ranged everywhere from about 5 (in 1921) to 44 (when Shiller published his book in 2000). Shiller found that these anomalies had predictable-seeming consequences for investors. When the P/E ratio is 10, meaning that stocks are cheap compared with earnings, they have historically produced a real return of about 9 percent per year, meaning that a $10,000 investment would be worth $22,000 ten years later. When the P/E ratio is 25, on the other hand, a $10,000 investment in the stock market has historically been worth just $12,000 ten years later. And when they are very high, above about 30—as they were in 1929 or 2000—the expected return has been negative.”
“Late at night, you’re flicking channels and see an infomercial for an amazing new product. It’s a little black box that, exactly once a year, spews out a pound coin. It’s perfectly legal, the presenter assures you, and you can spend the pound any way you want. The box will produce a pound this year, next year, the year after that, and so on – forever! How much would you pay for a product like that?”
“Benjamin Graham, the legendary founder of value investing, had a simple answer for the value of a 1 pound-a-year black box: £8.50. Graham was actually speaking of stocks. A share of stock produces a stream of future earnings. Divide the share price by earnings per share, and you have the price-to-earnings (P/E) ratio. It tells you how much buyers are paying for £1 a year, The price you pay for it, in pounds, would equal it P/E ratio. In Graham’s analysis, the stock of a company with no earnings growth should sell at a price-to-earnings ratio of 8.5.”