When making sound investment decisions, few individuals command as much respect and admiration as Warren Buffett, the legendary investor and Chairman of Berkshire Hathaway. His wisdom has guided investors for decades, and his insights into the complex world of stocks are invaluable. One such concept that Buffett has shed light on is the price-earnings (P/E) ratio, a critical financial metric used by investors worldwide to evaluate companies. In a candid question and answer session, Buffett reveals how P/E ratios fluctuate and the factors that can cause them to move higher. This discussion provides crucial insights into the workings of the investment world, helping us understand how expectations, interest rates, and investor sentiment can affect a company’s P/E ratio.
Warren Buffett On P/E Ratios
Warren Buffett and Charlie Munger explain the reasons for higher price-earnings ratios in the below transcript from the 1998 Berkshire Hathaway annual meeting.[1]
The question asked, “Thanks for the beautiful, beautiful weekend in Omaha. I’m Micah Sail from New York City with a question for Warren and Charlie about what makes a company’s price-earnings ratio move up relative to other companies in its industry. How can we, as investors, find companies and even industries that will grow their relative price-earnings ratios, as well as their earnings? And thank you for the wonderful weekend and for sharing your brilliance with the shareholders.”
Warren Buffett replied, “Oh, thank you, thank you. Yeah, you know, it’s very simple. That price-earnings ratio, relative price-earnings ratios move up because people expect either the industry or the company’s prospects to be better relative to all other securities than they have been, than their preceding view. And it can turn out to be justified or otherwise.”
“Absolute price-earnings ratios move up in respect to the earning power, or the prospective earning power of that, as viewed by the investing public, of future returns on equity, and also in response to changes in interest rates. In recent years, well, really ever since 1982, but extension in recent years, you’ve had decreasing interest rates pushing up stocks in aggregate. You’ve also had an increase in corporate profits. The return on equity of American businesses has improved dramatically recently, and people are starting to believe it. So, that has pushed up absolute price-earnings ratios.”
“And then, within that universe of all stocks, when people get more enthusiastic about a specific business or a specific industry, they will push up the relative P/E ratio for that stock or industry.”
“Charlie, you have anything?”
Charlie Munger adds, “Yes, I think he also asks how do you forecast these improvements in price-earnings ratios. That’s your part of the question. Around here, I would say that if our predictions have been a little better than other people’s, it’s because we tried to make fewer of them.”
Warren Buffett interjects, “We also try not to do anything difficult, which ties in with that.”
“We really do feel that it’s – you get paid just as well. You know, this is not like Olympic diving. In Olympic diving, you know, they have a degree of difficulty factor, and if you can do some very difficult dive, the payoff is greater if you do it well than if you do some very simple dive. That’s not true in investments. You get paid just as well for the most simple dive as long as you execute it alright. And there’s no reason to try those three and a halves when you get paid just as well for just diving off the side of the pool and going in cleanly.”
“So, we look for one-foot bars to step over, rather than seven-foot or eight-foot bars to try and set some Olympic record by jumping over. And it’s very nice because you get paid just as well for the one-foot bars.”
Warren Buffett P/E Ratio Rules
Warren Buffett has spoken and written at length about his investment philosophy. Though he doesn’t provide a step-by-step guide about using P/E ratios, some principles from his overall investing approach can be extrapolated to using this financial metric. Here are four guidelines for investing using P/E ratios based on Buffett’s principles:
- Look for Value, Not Price: Buffett is a known value investor. A company might have a high or low P/E ratio, but that doesn’t necessarily indicate whether it’s a good or bad investment. A lower P/E may mean the company is undervalued (a potentially good buy), while a higher P/E might indicate overvaluation (potentially overpriced). However, Buffett advises looking beyond just the P/E ratio to truly understand a company’s inherent value, including its management, competitive advantage, financial health, and future growth potential. The quality and durability of discounted future cash flows is Buffett’s favorite fundamental metric for valuation.
- Consider the Industry: Different industries can have very different average P/E ratios. A good P/E ratio for a tech startup might be very high, while it might be much lower for a utility company. Buffett suggests understanding the industry context when considering the P/E ratio.
- Think Long Term: Buffett often emphasizes the importance of investing in the long term. If a company has a high P/E ratio because it’s expected to grow significantly, it’s crucial to consider whether this growth is sustainable in the long term. High growth expectations can sometimes lead to disappointment if they don’t materialize.
- Understand the Business: Buffett’s most quoted rule is “Never invest in a business you can’t understand.” Suppose you use the P/E ratio as part of your investing strategy. In that case, it’s essential to understand what the company does, how it makes money, and the financial and market factors that could impact its earnings and, consequently, its P/E ratio.
Remember, while P/E ratios can be helpful, they are just one factor to consider in the investment decision-making process. Buffett’s approach emphasizes a comprehensive understanding of a company’s value, industry context, and long-term prospects.
Key Takeaways
- Increased expectations around a company or industry’s future potential can increase the relative price-earnings (P/E) ratio.
- An upswing in the absolute P/E ratio correlates with the perceived future earning power and responses to shifts in interest rates.
- Periods of declining interest rates can stimulate a surge in stocks overall and a concurrent rise in corporate profits.
- The absolute P/E ratio can also be boosted by enhanced investor confidence in American businesses’ return on equity growth.
- Investors excited about a particular sector or company can increase that entity’s relative P/E ratio.
Conclusion
Warren Buffett delineates how P/E ratios fluctuate based on several factors, including investor sentiment about a company or industry’s prospects, perceived future returns on equity, and changes in interest rates. As interest rates decline and corporate profits rise, stocks generally get a lift, which bolsters P/E ratios. Investor enthusiasm for specific businesses or sectors can also spur growth in relative P/E ratios. Buffett underscores the importance of simplicity in investment strategy, advising against unnecessary complexity or overambition. He suggests a systematic approach of selecting ‘one-foot bars to step over,’ implying that choosing less complicated investments that promise steady returns is a better path to success. This conclusion reiterates the importance of understanding market dynamics, investor sentiment, and the underlying economic conditions when evaluating the P/E ratios of companies or sectors.