The first reason why P/E10 is an investor’s best friend is that it tells you the price you are paying for the stocks you buy.
You wouldn’t buy a house or a car without first inquiring about the price. You may over the course of your lifetime spend more money buying stocks than you do buying houses or cars. You need to be checking the price-tag on the stocks you buy before you purchase them.
P/E10 tells you what you need to know to know whether stocks are a good buy at the moment or not. The fair-value P/E10 number is 14. Stocks are an excellent buy at that price level. When stocks are available at a lower price, they are a bargain. When the number goes below 10, stocks are a steal.
When the P/E10 rises above 20, watch out! That’s the danger zone, the time when the risk of a big price drop is so high that it is questionable whether a middle-class investor can afford to have too high a percentage of his portfolio tied up in stocks.
The second reason why P/E10 is an investor’s best friend is that it is simple.
Some analytical tools of great power are intimidating in their complexity. This is not so of our friend P/E10! Understanding P/E10 is easy-peasey.
The “P” stands for “Price.” The “E” stands for “Earnings.” When the P/E10 is 8, you are paying eight dollars for each dollar of annual earnings generated by the companies in the index fund you are purchasing (articles at this site describe strategies for purchasing shares in the S&P index, except when otherwise noted). That’s a fantastic deal. That means that in eight years you have recovered the entire price of your investment in earnings generated by it. Ask investors who bought into the S&P in 1982 how buying stocks priced at a P/E10 of 8 works out in the long term!
The third reason why P/E10 is an investor’s best friend is that it is not overly simple.
Simple is good. Excessively simple is not so good.
The more common way to assess stock valuations is to look at the plain price-earnings ratio, what might be called P/E1. That doesn’t work so hot.
The problem is that long-term investors will be holding stocks through economic recessions and through economic recoveries. Use P/E1 as your guide to the price of the stocks you buy, and you obtain a lot of false reads. If you happen to be making your purchase during an economic good time, earnings will be artificially inflated for the purposes for which you are making the comparison between price and earnings. If you happen to be making your purchase during an economic bad time, earnings will be artificially deflated.
P/E10 smoothes out the effect of economic downturns and upturns by averaging out 10 years of earnings. Makes sense, no?
The fourth reason why P/E10 is an investor’s best friend is that P/E10 is the valuation assessment tool used by the smartest investing analysts in the business.
You’ve probably heard of Robert Shiller, the author of Irrational Exuberance. Guess what valuation assessment tool Shiller uses to determine when stocks are mispriced? P/E10.
P/E10 is not a valuation assessment tool that came along only in recent years, however. The best investing analysts cite the book Security Analysis as the “Bible” of the field. Guess what valuation assessment tool was used by Benjamin Graham, co-author of that text? Graham also used a version of the price-earnings ratio featuring a smoothed-out earnings component.
John Walter Russell is the best-respected Numbers Guy in the Financial Freedom Community. Guess what valuation tool Russell uses in the research he publishes for us at his www.Early-Retirement-Planning-Insights.com web site? P/E10.
If it’s good enough for Shiller and Graham and Russell, it’s good enough for me. I think it ought to be good enough for you too.
The fifth reason why P/E10 is an investor’s best friend is that it works.
It don’t mean a thing if it ain’t got that swing.
Does P/E10 work?
Here’s a link to an article at Russell’s site at which he discusses the P/E10 tool.
His conclusion, in layman’s language, is — P/E10 works. It does the job you need for it to do.
The sixth reason why P/E10 is an investor’s best friend is that it doesn’t work perfectly.
Do you get suspicious when something sounds too good to be true? I do. That’s one of the reasons why I don’t buy the line we’ve been hearing since stock prices went to nosebleed levels that valuations don’t really matter that much anymore. Uh-huh, sure, ah, thanks for passing that one along, friend, I’ll be calling you, I don’t know exactly when, but I’ll be sure to give you a call back someday soon.
The line about valuations not mattering is phony baloney stuff. Valuations have always mattered in the past and there is no good reason why they shouldn’t continue to matter today. Is the line about P/E10 working another line of bull coming from the other side of the table? Is P/E10 really a miracle tool?
It’s not a miracle tool. It is critical for all investors to have a valuation assessment tool, and P/E10 appears to be the best one out there. So I think it is fair to say that P/E10 is an investor’s best friend. But it’s not a perfect tool. Like everything else in this Valley of Tears, it has its flaws.
That just tells me that P/E10 is real. It’s not part of some “system” for investing that works in backtesting, but not in the real world.
If you want to know how good a job P/E10 does of letting you know when stocks are a steal and when stocks are best left for others to purchase, check out the P/E10 values that applied at earlier times in history and see how you would have done if you had followed the insights offered by P/E10 on those occasions.
I’ll tell you what you’ll find. You’ll find that P/E10 works reasonably well. It doesn’t work perfectly. It works well enough that, if you check it out for yourself, my guess is that you will never again want to make a purchase of shares in the S&P index without first taking into consideration the P/E10 level that applies at the time of purchase.
Looking at P/E10 won’t turn you into Warren Buffett overnight. If you have been feeling tempted to give in to the seemingly relentless pressures to ignore today’s valuations (this article was written in October 2006, when the P/E10 level was 28) and make stock purchases on a hope, a wish and a prayer that “it’s different this time,” P/E10 just might save your neck.
The seventh reason why P/E10 is an investor’s best friend is that it is easy to check out.
I suggested above that you might want to check out the power of the P/E10 valuation assessment tool by yourself. If you are like me, you don’t like messing about with numbers. So you might be more than a bit disinclined to take me up on that advice.
Please reconsider.
You don’t need to know hardly anything about numbers to see how the P/E10 tool has been helping informed investors achieve long-term success for decades now. Go to Robert Shiller’s web site (click the tab for “stock data” after following the link). He lists the P/E10 value that applied for every year from 1880 forward. You can view a table showing the corresponding long-term stock returns at Russell’s site. See if P/E10 shapes up as a useful tool in your estimation.
Why not head on over to the Shiller site when you finish this article? That way you won’t have to take my word on how great a tool the P/E10 tool is. You can see it (or not see it) for yourself. That’s as it should be.
The eighth reason why P/E10 is an investor’s best friend is that the other good valuation assessment tools back it up.
As good as the P/E10 tool’s track record is, I would be skeptical of what it is telling us about the risks of investing in stocks today if it were telling us a story at odds with the other valuation assessment tools with good track records. It isn’t. Other tools that work reasonably well are the dividends-payout ratio for the S&P index (when it’s low, stocks are trouble) and Tobin’s Q (See the book Valuing Wall Street: Proctecting Wealth in a Turbulent Market). These tools generate findings much in line with the findings generated by the P/E10 tool. That suggests that the P/E10 tool is probably not steering us wrong.
The ninth reason why P/E10 is an investor’s best friend is that it is easy to apply.
The P/E10 tool does not give precise enough readings to permit fancy-Dan footwork by the Valuation-Informed Indexer. If anyone tells you that you should sell all of your stocks when the P/E10 level goes above 18 and when the moon is full and when there is an “r” in the name of the month, please direct a raspberry in his direction on my say-so. That sort of thing gives valuation-informed investing strategies a bad name. Let’s all do what we can to put a stop to the nonsense.
You don’t need to follow any complicated system to obtain great benefits from the P/E10 tool. It tells you when stocks are priced low, it tells you when stocks are priced high, and it tells you when stocks are priced right. You take in the information provided and then consider all of the non-valuation factors that you need to take into account to make the best decision for You, Inc.
You sometimes buy a car even if it is priced a bit high, right? Please do the same with your stock purchases.
If you see a car that is priced well at a time when you are not looking for a car, you might take a pass, right? Please do the same with your stock purchases.
P/E10 tells you whether stocks are priced well or not. Price is not the only consideration that goes into making an intelligent stock purchase. Use the tool in the way that it should be used, and it is easy to apply. Get too fancy, and it says here that there is a good chance that you are going to get hurt.
The tenth reason why P/E10 is an investor’s best friend is that it adds to your confidence in your stock purchases.
Buy-and-hold, buy-and-hold, buy-and-hold, buy-and-hold, buy-and-hold.
You’ve heard it so many times that you are sick of it. What does it mean?
Just about everyone likes the sound of the words “buy-and-hold.” Very few provide useful information on how to pull it off in the real world.
Here is a short phrase that I believe offers useful advice on how to pull off buy-and-hold in the real world — Use the P/E10 tool.
If you use the P/E10 tool, you are less likely to get blindsided by the long-term results of your stock purchases. Learn what to expect for the long-term at the time you make a stock purchase, and you are far more likely to walk the buy-and-hold walk as well as to talk the buy-and-hold talk.
P/E10 truly is an investor’s best friend.
P/E10 rocks!