Reading: The P/E Ratio

Practitioners sometimes use the P/E ratio as an investment decision criterion. The idea is very simple: Since the P/E ratio indicates how many dollars the market pays for one dollar of earnings, firms with a comparatively low P/E ratio are "cheap," in the sense that an investor has to pay a smaller price to access the firm's future earnings stream. In contrast, for a firm with a comparatively high P/E ratio, the investor has to pay a higher price to access future earnings, hence the firm with a high P/E ratio is deemed "expensive." The decision criterion therefore is to buy firms with a low P/E ratio (and sell firms with a high P/E ratio).

This investment rule only works if we are dealing with identical firms because identical firms should trade at the same P/E ratio. If we observe a situation where identical firms have different P/E ratios, buying the low-P/E firm and selling the high-P/E firms should indeed be a profitable investment strategy because we would expect the different P/E ratios to converge over time. In such a situation, the P/E ratio would allow us to identify a mispricing on the market, and the described strategy would help us exploit that mispricing.

The problem is that the main reason for why we observe different P/E ratios for similar firms is usually not market mispricing. The previous section has shown that the P/E ratio is not a valuation method in itself but rather a metric that summarizes the three value drivers payout policy, risk, and future growth. To the extent that (similar) firms differ with respect to these three value drivers, their fairly priced P/E ratios might also differ. In such a situation, which is the rule rather than the exception, an investment strategy that buys low-P/E and sells high-P/E firms should not produce any abnormal returns.