It's really tough for an investor to remain upbeat and hold investments whose
prices are plummeting in the throes of a down market. And
it's equally difficult to be realistic and patient
(the cornerstones of successful investing) when the stock market is
soaring. By assessing the rational
price of a stock and the
rational value of your
portfolio, you can make sensible choices when others overreact.
Many shareholders fail to realize that there is a finite,
absolute—though approximate—value for each share of
stock. When viewed over a fiveyear period, the shortterm ups and
downs of a stock's price generally vary on either
side of a value that's tied to the earnings of the
underlying company. When you select successful companies capable of
growing their earnings at a substantial rate, the underlying value of
your shares should climb as well.
The relationship between a company's earnings and
its stock's price is measured by the price to
earnings ratio
and is calculated by dividing the price of a share of the stock by
the company's earnings per share. Called the P/E
ratio or multiple, this value is similar to the price per pound of
coffee or gallon of gas. The P/E ratio is the price investors are
willing to pay for a dollar's worth of the
underlying company's earnings.
The Signature PE
Because it fluctuates constantly with the price, looking at the
P/E ratio at any given moment isn't going to be that
helpful. However, the average of those P/E ratios over a significant
period of time can provide a typical, reasonable multiple of earnings
to which the P/E ratio returns from higher or lower values, shown in
. This value is called the
signature PE.
Table 0. Using ten years of P/E ratios to identify the signature PE
Year

EPS

High price

Low price

High PE

Low PE

1993

0.39

5.60

4.10

14.4

10.5

1994

0.47

6.00

4.20

12.8

8.9

1995

0.58

7.50

5.30

12.9

9.1

1996

0.68

11.00

7.10

16.2

10.4

1997

1.04

14.50

9.40

13.9

9.0

1998

0.88

22.70

11.30

25.8

12.8

1999

1.04

28.40

19.50

27.3

18.8

2000

1.14

37.50

16.80

32.9

14.7

2001

1.28

36.10

23.00

28.2

18.0

2002

1.55

33.50

23.10

21.6

14.9

Median values




18.9

11.7

Average or signature PE





15.3

Until the end of the twentieth century, looking at the average P/E
ratio over a fiveyear period seemed adequate because the average
economic or business cycle ran its course in that length of time.
However, the duration and amplitude of the most recent boom and
ensuing bust have shown that we must consider an average P/E ratio
over a longer period of time.
To arrive at a signature PE, the best approach is to calculate the
high and low P/E ratios for the last ten years, calculate their
medians to eliminate anomalous data above and below, then average the
resulting values. Unlike an average, the median is the value with
equal numbers of entries above and below. If there is an even number
of values, the median is the average of the two middle values of the
set of numbers.
shows the calculation for the signature
PE using the high and low prices and the earnings data for Aflac Inc.
(AFL), the insurance company. When you consider that the signature PE
represents a reasonable rate to pay for a dollar's
worth of Aflac's earnings, it's
easy to see in that there were
times—indeed entire years—when investors paid more than a
reasonable P/E ratio and times when they paid less. By its
definition, the average multiple paid for this stock was above the
signature PE about half the time and below it the other half.
When the current P/E ratio is above the signature PE, the P/E ratio
is likely to eventually decline; if the P/E ratio is below, it should
sooner or later grow. Looking at the chart in , you can see that, although the amplitude of
the swing above or below might vary, the P/E ratios rise or fall to
gravitate toward the signature PE.