Stock Market School: In-Depth Analysis of the P/E Ratio!

Valuing stocks from the perspective of return on investment aligns more closely with real-world business operations. VIII. The P/E Ratio Through the Eyes of Investment Masters (a) Peter Lynch’s PEG Ratio The PEG ratio (Price/Earnings to Growth ratio) is calculated by dividing a company’s P/E ratio by its earnings growth rate. Developed by renowned fund manager Peter Lynch, the PEG ratio builds upon the traditional P/E valuation metric and addresses the P/E ratio’s limitation in capturing a company’s dynamic growth potential. Specifically, the PEG ratio guides investors to prioritize companies with higher growth rates when P/E ratios are equal across peers—or, conversely, to select companies with lower P/E ratios when growth rates are identical. The PEG ratio is computed by dividing the current P/E ratio by the company’s expected compound annual growth rate (CAGR) in earnings per share (EPS) over the next three or five years. While the P/E ratio reflects only a stock’s current valuation, the PEG ratio links that valuation to the company’s future growth prospects. For example, a stock trading at a P/E of 30 may appear expensive under traditional P/E analysis—but if its projected 5-year EPS CAGR is 30%, its PEG ratio equals 1, suggesting fair value. A PEG of 1 indicates that the market’s current valuation fully reflects the company’s anticipated earnings growth. A PEG above 2 implies that profit growth is lagging behind valuation expectations—potentially signaling severe overvaluation. Conversely, a PEG below 0.5 suggests profit growth significantly outpaces valuation expectations—possibly indicating severe undervaluation. The PEG ratio can also be interpreted as follows: for companies growing at 15–30% annually, a high current P/E of 20–30x may decline to a relatively safer range of 10–13x within three years. (Note: This logic does not apply to cyclical or low-quality stocks; for firms whose growth stems from financing, always use diluted EPS growth rates.) Thus, the PEG ratio is most meaningful when applied to high-quality growth stocks. Ultimately, the PEG ratio tells investors that, relative to P/E-based valuation, greater emphasis should be placed on a company’s earnings growth trajectory. In the short term, stocks with high earnings growth tend to perform strongly—even if their valuations already appear stretched. Important caveat: One can reverse-calculate an appropriate current P/E using the PEG = 1 benchmark based on projected 3-year earnings growth. However, when buying, even exceptional blue-chip stocks trading below 20x P/E should have a PEG no higher than 1.5; for solid performers trading above 20x P/E, the PEG should ideally remain below 1—since such high growth rates are often unsustainable. (b) The Davis Double Play This strategy involves buying stocks at low P/E ratios and selling them later at high P/E ratios once their growth potential becomes evident—thereby capturing multiplicative gains from both rising earnings per share *and* expanding P/E multiples. This approach is known as the “Davis Double Play”; the opposite scenario is termed the “Davis Double Kill.” The Davis Double Play was pioneered by Shelby Cullom Davis. In 1950, Davis purchased insurance stocks trading at a P/E of just 4x. Ten years later, the sector’s P/E had risen to 18x. That is, when earnings per share stood at $1, Davis bought at $4. As the company’s earnings grew to $8 per share, a wave of followers rushed in—and bought at $8 × 18 = $144.

These 3 Factors Could Drive Stock P/E Ratios Higher in the Future

Original article by Tu Fu 1868, published on Jiyechanghong, April 28, 2024, 21:22, Guangdong Province “The best way to predict what will happen in the future is to remember what has happened in the past.” — George Savile This is Tu Fu’s 925th original article, totaling 3,000 characters. This piece is a republished version of an earlier article originally released in November 2019, titled “Siegel: Three Factors That Will Push Future Stock P/E Ratios Higher.” Timeless insights never go out of style—hope this still proves helpful to you. This edition includes a newly added section titled “A Small Update Five Years Later”—be sure to read until the end! Money · Logic · Going Against Human Nature — Tu Fu wishes you a good evening. The bilingual (Chinese-English) translation of Ray Dalio’s views received strong feedback—an unexpected success for such technically dense content. (Tu Fu’s note: That translation remains highly time-sensitive and will not be re-posted; those interested can click the link to see whether Dalio’s statements from five years ago have since been contradicted.) That article touched upon two major arenas of financial assets: equity instruments (stocks) and debt instruments (bonds). Today, we refocus our attention on equities—and examine Professor Jeremy Siegel’s perspective on future stock valuation metrics. This article draws primarily from a brief but highly insightful section in Siegel’s classic *Stocks for the Long Run*, supplemented by Tu Fu’s own organization and synthesis—offering fresh perspectives for readers. Future Stock Market P/E Ratios Based on 210 years of stock market data, Professor Siegel concluded: • The long-term real annual return on stocks is approximately 6–7%, • which corresponds to an average P/E ratio of roughly 15x. How do we interpret this “annual return”? Breaking down the P/E formula reveals: P/E Ratio = Stock Price / Earnings Per Share (EPS) In plain terms, a stock’s P/E ratio reflects “how much the market is willing to pay for a company’s future earnings.” Taking the reciprocal—EPS / Stock Price—yields “how much earnings each invested yuan generates per year,” i.e., the “annual return.” Since 1 ÷ 15 ≈ 6.67%, Siegel states that a 6–7% annual return aligns with a P/E ratio around 15x. However, P/E ratios fluctuate with market conditions. Three significant shifts have emerged in today’s economy and financial markets. In the foreseeable future, these factors will push P/E ratios upward. Factor 1: Declining Transaction Costs Although historical data spanning two centuries supports the conclusion that stocks deliver a real annual return of 6–7%, Siegel himself believes investors are unlikely to replicate those returns going forward. The primary reason lies in transaction costs. Stock trading costs—including brokerage commissions and bid-ask spreads—have steadily declined throughout the 20th century. According to research by Charles Jones of Columbia University, the average per-trade cost of buying and selling U.S. equities fell from 1% in 1975 to 0.18% in 2002. By the time the 5th edition of *Stocks for the Long Run* was published in 2012, this cost had fallen even further.