Imagine the village bakery is up for sale. It makes CHF 50,000 a year once everything is paid. The baker is asking CHF 500,000. Is that expensive? To answer, investors have used a simple calculation for nearly a century: the P/E ratio.
In short: the P/E ratio (price-to-earnings ratio) is the price of a business divided by its annual profit. It tells you how many years of profits it would take to "pay back" the price you paid.
The bakery's P/E ratio
CHF 500,000 ÷ CHF 50,000 = 10. The P/E ratio is 10: if profits stay the same, it would take 10 years for the bakery to "pay you back".
A second bakery, in the next town, also makes CHF 50,000 a year, but costs CHF 1,500,000. Its P/E ratio is 30: 30 years to get your money back.
Another way to look at it: with a P/E of 10, every franc invested earns 10 centimes of profit a year. With a P/E of 30, about 3 centimes.
On the stock market, it's the same sum for a tiny slice of a company: the price of one share divided by the slice of profit belonging to that share.
Is a low P/E always a bargain?
No. If the second bakery costs more, it may be because it's growing fast: in five years it might earn twice as much. Conversely, a very cheap business is sometimes cheap because its customers are leaving. The P/E ratio is a question, not an answer: "Why this price?"
The good-year trap
As early as 1934, Benjamin Graham and David Dodd, who taught at Columbia University, issued a warning: one year's profit can be misleading. An ice-cream parlour after a heatwave summer looks very profitable… until the rainy summer. They advised looking at average profits over several years, ideally seven to ten.
Example: over five years, an ice-cream parlour makes CHF 20,000, 5,000, 12,000, 18,000 and 10,000. The average is CHF 13,000. Working out the P/E on the best year alone would give a far too flattering picture.
The modern version
In 1998, the economists John Campbell and Robert Shiller (Nobel Prize 2013) applied this idea to the whole American stock market: price divided by the average of the last ten years' profits, adjusted for rising prices. What they found: when this P/E was very high, returns over the following ten years were lower on average. In 1998 it was close to its historic highs, and the following decade did indeed turn out disappointing for American shares.
It isn't a crystal ball for next year. It's a compass for the long term.
Try this tonight with your child
Invent two pancake stalls. Stall A makes CHF 10 a weekend and sells for CHF 100. Stall B also makes CHF 10, but sells for CHF 300. Ask: "How many weekends to pay back each stall?" (10 and 30.) Then: "Why would anyone pay more for stall B?" Let them come up with reasons: a better spot, a new recipe… They've just done their first analysis.
Read also: When a company says thank you · How much does it really earn?
Further reading
- Graham, B. & Dodd, D. L. (1934). Security Analysis. New York: Whittlesey House (McGraw-Hill).
- Campbell, J. Y. & Shiller, R. J. (1998). Valuation Ratios and the Long-Run Stock Market Outlook. Journal of Portfolio Management, 24(2), 11–26.
Teach them to recognise a fair price. Join the Mangosteen Buddy waitlist: Book 1 of the comic is free, and the first 500 families get their first year of Premium on us (worth CHF 150). Save my place
Educational content, not investment advice. Past returns are no guarantee of future returns.