“The arithmetic here is deceptively simple. If a company’s earnings will increase 15% this year, and if the P-E ratio remains unchanged, then presto! The “investment” shows a 15 percent performance, plus the small dividend. If the P-E ratio advances—as it did for Avon in almost every year–the performance becomes that much better. These results are entirely independent of the price levels at which these issues are bought. Of course, in this fantasia, the institutions were pulling themselves up by their own bootstraps–something not hard to do in Wall Street, but impossible to maintain forever.”
This shows how the ratio of the S&P 500’s price to earnings has changed over time. Given that the historical average is just above 15, this graph hopefully puts the 90 times earnings that investors willingly paid during 1972 and early 1973 into perspective. The S&P 500’s P/E ratio for the period hovered in the sub 10 levels while the Nifty Fifty traded at upwards of 60 times earnings. This brought about what Fortune called a two tiered market which, following the collapse in 73-74, noted, “The two-tier market really consisted of one tier and a lot of rubble down below.” What happened is that this upper tier had nothing to stand on. It was effectively, “pulling itself by its own bootstraps” to stay afloat and, given the rising interest rates of the period, it was only a matter of time before the floor fell out from underneath investors. A group of stocks cannot deviate from the rest of the market by such a degree indefinitely.
This illustrates how P/E Ratios can actually serve to be a double edged sword. By nature, the ratio attempts to incorporate some notion of risk into its value because the price takes into account a company’s future prospects for earnings. Consequently, the ratio is more accurately a measure of what investopedia.com calls “market optimism” with regards to a company’s future earnings. Companies with comparatively high P/E ratios are seen by the market to have high potential for growth in future earnings and are valued higher. Conversely, companies with low P/E ratios are seen to have low potential for growth earnings and are valued lower. However, as seen by 1973, the market doesn’t always judge companies with complete accuracy. This ties in well with a favorite saying of Ben Graham, “You are neither right nor wrong because people agree with you.” Just because the market is optimistic about a company’s growth prospects does not mean that it will grow and during periods of widespread optimism it’s easy for investors to make impulsive judgments about companies. A high P/E ratio could signify a company that is about to have record earnings but it could also just a company that has been driven up by speculator interest. The moral of the story is that P/E ratios are only a small part of the picture. It is much important is to identify why a P/E ratio is low or high and how it compares to the industry and market P/E ratios.