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.
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.
Practical Application
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.
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.
Buffett's Own Words
You simply can’t buy high quality businesses at the sort of price/earnings multiple likely to prevail on our bank sale. Financial Reporting During 1979, NASDAQ trading was initiated in the stock of Berkshire Hathaway This means that the stock now is quoted on the Over-the-Counter page of the Wall Street journal under “Additional OTC Quotes”. Prior to such listing, the Wall Street journal and the Dow-Jones news ticker would not report our earnings, even though such earni
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. Experience, however, indicates that the best business returns are usually achieved by companies t
Sometimes there is more to stock valuation than price-earnings ratios. In recent years, most arbitrage operations have involved takeovers, friendly and unfriendly. With acquisition fever rampant, with anti-trust challenges almost non-existent, and with bids often ratcheting upward, arbitrageurs have prospered mightily. They have not needed special talents to do well; the trick, a la Peter Sellers in the movie, has simply been “Being There.” In Wall Street the old prove
"value" purchase. 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
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. Berkshire, in contrast, happily a
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