Price-Earnings Ratio
The price-to-earnings ratio divides a stock's price by its earnings per share, providing a quick measure of how expensive a stock is relative to its current profits.
Concept Analysis
Definition & Origins
The price-to-earnings ratio divides a stock's price by its earnings per share, providing a quick snapshot of how much the market charges for each dollar of current earnings. Buffett uses P/E ratios cautiously — as a starting point for thinking, not a conclusion — because reported earnings can diverge dramatically from the economic reality of a business's cash-generating capacity.
The ratio came to Buffett through Graham, for whom a low multiple was half of the original bargain equation: earnings power bought cheaply. The partnership years were built on that arithmetic. But by 1979 the limits of the simple ratio were already explicit in the letters. Forced by the Bank Holding Company Act of 1969 to divest the Illinois National Bank and Trust Company — a bank Gene Abegg had run superbly since Berkshire's 1969 purchase — Buffett warned shareholders that the sale proceeds could not replace what was being given up: high quality businesses simply do not trade at the sort of price/earnings multiple a forced bank sale would fetch. The multiple at which a mediocre business trades and the multiple at which a fine one trades are not two points on one scale; they measure different things.
Core Ideas
Earnings yield vs. bond yield. The inverse of P/E is the earnings yield. A business at 20x earnings has a 5% earnings yield; if 10-year Treasury bonds yield 4%, the equity risk premium (roughly 1%) may be adequate or may not be, depending on the quality and growth trajectory of those earnings. This comparison is Buffett's primary frame for evaluating absolute market valuation, not absolute P/E levels.
GAAP earnings are often misleading. Amortization of acquisition-related intangibles, stock-based compensation excluded from 'adjusted' earnings, restructuring charges for recurring events — all cause GAAP earnings to diverge from owner earnings (the cash that can actually be extracted). A business with 15x GAAP earnings but 20x owner earnings is more expensive than it appears; one with 20x GAAP earnings but 15x owner earnings is cheaper.
Growth rate transforms the P/E analysis. A 30x P/E on a business compounding earnings at 20% annually for 10 years delivers the same total return as a 15x P/E on a business with flat earnings, if both are held the full period. The P/E is a static ratio; total returns are dynamic functions of earnings growth, competitive durability, and holding period.
Volatility depresses the multiple. The 1998 letter observes that wide swings in reported earnings hurt both credit ratings and P/E ratios, even when the business producing the swings earns satisfactory profits over time. Markets pay less per dollar for unpredictable earnings than for smooth ones — which is precisely why Berkshire, structurally indifferent to reported volatility, can retain reinsurance business that publicly-graded competitors feel forced to lay off.
Practical Application
The Illinois National Bank divestiture (1979–1980). Berkshire was required to sell one of the best-run banks in its portfolio. Whatever multiple the sale fetched, Buffett told shareholders, the proceeds could not be redeployed into a business of equal quality at an equal multiple. The episode is the cleanest early statement in the letters that a P/E number detached from business quality conveys almost nothing — the bank at a low multiple was worth more than the cash it would bring.
Coca-Cola (1988). Buffett's Coca-Cola investment exemplifies P/E analysis done correctly: in 1988, Coca-Cola traded at what appeared to be a significant premium to the S&P 500 average P/E. Value investors using mechanical P/E screens would have passed. Buffett's view: the appropriate P/E for a business with global distribution, century-old brand loyalty, and the ability to grow earnings at 15% annually was much higher than the market average P/E. The 'expensive' stock was actually cheap.
Rockwood & Co. (1954, retold in the 1988 letter). When Buffett was 24 and working at Graham-Newman, Jay Pritzker's cocoa-bean restructuring sent Rockwood stock from 15 to 100 while the company was reporting large operating losses. A P/E computed on those earnings would have been meaningless. For asset conversions, liquidations, and arbitrage, value lives in the balance sheet and the deal terms, not in the year's earnings — sometimes there is more to stock valuation than price-earnings ratios.
Common Misconceptions
Misconception 1: Low P/E means value. A business at 8x earnings that requires ongoing capital investment at below-market returns, faces secular competitive decline, and operates in a structurally unattractive industry is not cheap at 8x — it is a value trap. Continental Airlines, Sears, and Kodak all appeared 'cheap' on P/E ratios for years before their competitive deterioration became impossible to ignore.
Misconception 2: High P/E means overvaluation. Apple at 25-30x earnings with $100B+ in annual free cash flow, 40%+ share repurchase programs, and ecosystem lock-in growing annually is not obviously overvalued. The multiple must be evaluated against the quality, durability, and growth trajectory of the earnings — not against an absolute standard.
Misconception 3: Growth justifies any multiple. Growth adds value only when the capital it consumes earns more than that capital costs. The 1992 letter's airline example is the standing warning: investors poured money into the domestic airline business to finance profitless growth, and the more the industry grew, the worse the disaster for owners. A high P/E is validated only by growth that increases per-share intrinsic value after its full capital requirements.
Buffett's Own Words
However, you should be aware that we do not expect to be able to fully, or even in very large part, replace the earning power represented by the bank from the proceeds of the sale of the bank. You simply can’t buy high quality businesses at the sort of price/earnings multiple likely to prevail on our bank sale.
That is, they usually confer the highest price-earnings ratios on exotic-sounding businesses that hold out the promise of feverish change. That prospect lets investors fantasize about future profitability rather than face today's business realities. For such investor-dreamers, any blind date is preferable to one with the girl next door, no matter how desirable she may be.
From shortly before the tender until shortly after it, Rockwood stock appreciated from 15 to 100, even though the company was experiencing large operating losses. Sometimes there is more to stock valuation than price-earnings ratios.
Similarly, business growth, per se, tells us little about value. It's true that growth often has a positive impact on value, sometimes one of spectacular proportions. But such an effect is far from certain. For example, investors have regularly poured money into the domestic airline business to finance profitless (or worse) growth. For these investors, it would have been far better if Orville had failed to get off the ground at Kitty Hawk: The more the industry has grown, the worse the disaster for owners.
Wide swings in earnings hurt both credit ratings and p/e ratios, even when the business that produces such swings has an expectancy of satisfactory profits over time. This market reality sometimes causes a reinsurer to make costly moves, among them laying off a significant portion of the business it writes (in transactions that are called “retrocessions”) or rejecting good business simply because it threatens to bring on too much volatility.
Thought Evolution
Related Concepts
Case Companies
'Expensive' at a premium P/E to the market but genuinely cheap relative to long-term earning power
'Cheap' at a below-market P/E but structurally deteriorating: the P/E told one story, the competitive dynamics told another
Bought at nominal premium P/E; proved cheap relative to share repurchase program and ecosystem-driven earnings growth
Stock rose from 15 to 100 while reporting large operating losses: the extreme case of P/E irrelevance in asset-driven situations