Fundamental Analysis: How To (Part 2 - Price to Earnings Ratio)

Posted by Dan Hung

March 12, 2007

I’ve probably given you all more than enough time to read the Tweedy Browne article I mentioned in my last post. That being said, maybe some people are too lazy or just want to hear my wonderful re-cap of Price to Earnings - why and how we use it.

Why is price to earnings important? Unlike price-to-book ratio, we aren’t looking at how much we’re paying versus some measure of intrinsic value. Instead, we’re looking at a ratio telling us how much we’re paying for the money that a business makes. Since earnings, for the most part, can’t be taken for granted and rarely stay constant, why would this be important to us? Well, earnings are important for two reasons. First, earnings directly relate to dividends. It would stand to follow that, as equity holders of a company, you deserve a kick back of the earnings and the more earnings the better. Therein lies the first benefit of price to earnings especially if you’re concerned about using “fixed income-ish” quality of dividends as part of your investment strategy. Low price to earnings ratios typically correlate to higher yields!

Second, after dividends are given out (if they are given out at all), the company’s retained earnings are then reinvested in the business. Any reinvestment in the business ought to be good for you the equity holder of the company since this would directly increase the net asset value of the company you have ownership in. Will this necessarily affect the stock price? Not necessarily. Maybe, the only affect will be that an increased net asset value will just result in a lower price to book ratio. But, more often than not, this will not be the case. In all likeliness, this will necessarily have a positive effect on the stock price. And, tougher markets, net asset value will provide a base that you know the stock price should not fall below.

So, given these logical reasons for the benefits of paying lower price to earnings for your stock investments, how do we apply them? Well, the idea that retained earnings goes directly into improving the bottom line value of the company you’ve invested in raises one important corollary. You ought to look for stocks which are unleveraged. That is, when investing based on price to earnings, look for stocks that do not take on a lot of debt (low debt to equity ratios). As debt ought to be paid down, the benefits of extra retained earnings logically will not have as significant an effect on highly leveraged companies. Along these lines, Benjamin Graham, the father of value investing and fundamental security analysis, suggested investing in companies with low price to earnings ratios (specifically those with earnings yields, the inverse of price to earnings, above that of AAA rated bonds) provided that the company’s total debt was less than that of its book value. He also suggested a long-term approach with investment periods lasting a minimum of 2-years unless the security increased by 50% in the time span before that. Does this work? Well, research papers cited by Tweedy Browne found that this two-year investment strategy significantly outperformed the NYSE in every 2-year period between 1974 and 1981.