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Preface

Who is this book for?

The book is primarily aimed at investors who already know something about investing in shares, but is also suitable for market professionals and academics. Quite simply, readers should already know what a price–earnings ratio (P/E) is.

If you are a private investor, rest assured that the book assumes no prior knowledge of any particular accounting or finance terms. Everything covered is defined at the time. For more detail, many terms, in particular accounting terms, are explained in the Glossary at the back. There are however many new ideas presented, and beyond Part I even seasoned stock market investors will need to think hard.

The book is also suitable for investment analysts, fund managers or finance academics. If you have a finance MSc or MBA then you may find some of the explanations over-simplified, but you will also learn much that is new. Using the P/E to get the best investment results is far from a simple task once you get into the details, and you should also find much of interest here.

What does the book cover?

The book starts with the basics: the fundamentals of share prices and how earnings and P/Es are calculated in the UK. I then look at the value premium, which is the whole basis of using the P/E as an investment tool: low P/E shares, on average, outperform the market. I cover some of the models that believers in efficient markets have come up with to try to explain this inconvenient fact, and why those who believe in pervasive mispricing remain unconvinced. This group of value investors includes such illustrious figures as Warren Buffett – as well as your author.

The second half of the book gets into the details of the P/E: developments that have tried to improve it, and how some famous value investors have combined it with other measures. The P/E can be made into a powerful tool. But as with most powerful tools it can run amok if you don’t control it properly, check what it is telling you by looking at other statistics, and apply a liberal amount of common sense.

Structure of the book

Part I introduces the surprisingly short history of the P/E. Then, for the benefit of the majority of readers who have not done an MSc in Investment Analysis, I go through in detail how earnings and then P/Es are calculated. I use motor manual publisher Haynes as the practical example throughout the book. They are small enough to have reasonably straightforward accounts yet most readers should have heard of them.

Part II covers the value premium and some famous investors who use it. I also look at efficient market theorists’ models of how returns on stocks can be explained, some of the objections to them, and the half-way house of the popular Fama and French three-factor model.

Part III looks at some existing developments of the P/E such as the PEG ratio. I then go on to some of my PhD thesis work, since published as peer-reviewed academic papers and expanded and updated for this book. The P/E can be made into a much more powerful weapon in any investor’s armoury by applying a few relatively simple adjustments. However, the flawed results from the Naked P/E show the importance of taking into account other statistics beyond the P/E.

This is demonstrated in Part IV, where I cover two famous value investors and how they have put the P/E to work with other statistics, so as to identify value shares of reliable companies. The last chapter is some more original work, showing how you can combine the P/E with an as yet little known measure of a company’s financial stability to get outstanding and reliable investment results.

Acknowledgements

I would like to thank Richard Beddard for the huge contribution he made to earlier drafts of this book, and Stephen Eckett and Suzanne Anderson at Harriman House for the original suggestion, their support and patience. Thanks also to Werner DeBondt for agreeing to write the foreword. Along with Ben Graham’s The Intelligent Investor and David Dreman’s books, his 1985 paper with Richard Thaler Does the Stock Market Overreact? convinced me early on that misvaluation can be rife, even in a mostly efficient market.