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The Price Earnings Ratio Is Stupid


PE is upside down.

The P/E ratio is probably the most used metric for the valuation of stocks but it is stupid. We should use the inverse: Earnings divided by price, which might be called earnings yield, or EY.

There are two significant problems with P/E.

First, P/E blows up at zero earnings, a not uncommon occurrence. At zero earnings the P/E ratio is infinite. Because of this you cannot take the average of P/Es for a number of stocks. The average of P/Es could be totally dominated by a single stock with low earnings. To come up with a meaningful P/E for an industry or an Index you need to add all the individual earnings per share, probably including losses as negative numbers, then divide by the number of stocks to come up with the average of the earnings per share, and then calculate the average price of the shares, and then divided the average earnings by the average price.

The huge P/Es that result from low earnings also means that we rarely talk about negative P/Es , even though loss per share as a percent of stock price is meaningful.

While earnings frequently go negative, stock prices never go negative. Stock prices never go negative because the stockholder is not responsible for the debts of a limited liability company. That means the inverse of P/E, which I am calling earnings yield, does not blow-up ever; it just goes to zero and moves smoothly into a negative number with a loss. The average of a collection of EYs is meaningful, although it would be more meaningful if we took the weighted average of EYs to account for the EY of a big company being more important than a small company.

Second, the P/E ratio is not directly comparable to anything else. For example it cannot be directly compared to interest rates or dividend yield. It would be handy to compare EY to DY. If the dividend yield were greater than the earnings yield, you would immediately know that the dividends might be in trouble. You could also easily compare EY to the bond yield or your savings account’s interest rate.

While I am disappointed that some mathematically challenged people stuck us with an upside down metric, it is so ingrained that it is unlikely that PE will ever be replaced by EY. Fortunately I have a calculator that has a 1/x button.