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Chapter 1. History of the P/E

The P/E ratio is today the most commonly used valuation metric in the world.

Prof. Janette Rutterford, Open University, 2004

The P/E has a long history, but it has not always been the most popular way to value shares. Since the invention of stock markets up until less than 100 years ago, the dividend yield (DY) was the main figure every investor was interested in. The asset backing behind a company was also important. The P/E is, compared to these two, a relatively recent invention. Even the phrase ‘price–earnings ratio’ only became popular in the 1920s in the US. In the UK dividends were still what mattered up until the mid-1960s.

The world of investment to 1914: dividend yield is king

For centuries, at least since the time of the South Sea Bubble in 1720, dividend yield (DY) was the main ratio investors used to value their stocks. This is simply the ratio of the dividends paid out last year to the price of the stock. So if a stock costing £1 paid out 5p in dividends last year, the dividend yield of 5% compares favourably to the return available from a deposit account (in 2011), but of course involving the risk of capital loss should the share price fall.

In the US, bond issues during the 1800s and early 1900s outweighed stock issues three to one. The stock market consisted largely of railway stocks, with utilities and then industrials only becoming more important by 1900. In these circumstances it is hardly surprising that dividend yield was the favoured method of deciding whether a stock was cheap or expensive, because dividend yield could be directly compared to the yield on a bond.

In the UK, the stock market was more developed, even though the railway boom was equally active. One feature was how internationalised the stock market was: the majority of new issues was of foreign stocks and bonds. Another feature strange to a modern investor was the preponderance of debenture and preferred stocks. In a new issue from an established investment-grade company, these were often the only type of stock an investor could buy. The founders would keep control of the ordinary stock. It was speculative companies that issued ordinary shares.

Even in the UK though, DY was the main statistic that investors were interested in. This could have been due to the limited information published in what we now call an IPO (Initial Public Offering) (this term is itself only about twenty years old). The only information a purchaser of a new issue would likely get would be profits averaged over several years (to even out the ups and downs), money available to pay the ordinary dividend after paying the preferred shareholders, and the balance sheet. Given the limited information made public in those days, it is not surprising that a more sophisticated analysis of company earnings was not yet possible.

The US in the 1920s: enter the P/E

DY in the US maintained its hold until the mid-1920s. The P/E only really became popular during the boom years of the late 1920s. Earnings themselves had boomed since the Great War. People were more interested in earnings growing at 10% or 25% annually than dividends growing at 5%. Everyone believed that this long-term growth could be kept up indefinitely due to rapid technological change. US company accounts were also generally more informative than in the UK, so that investors in US companies could see what was happening to retained earnings. They could appreciate the fact that the effect of compound interest on a company’s growing reserves would mean higher dividends and hence higher share prices in the future. Ben Graham and David Dodd could already comment in their 1934 classic Security Analysis:

Common stocks have come to depend exclusively on the earnings exhibit.

Catching up with the US

Meanwhile, DY remained for decades the main valuation ratio in the UK. Earnings were overwhelmingly paid out as dividends, whereas in the US a significant proportion was held back as undistributed profits. UK corporate earnings had themselves not shown the long-term rapid growth that US companies had experienced, so the gap between the two valuation methods was not as marked.

Relatively uninformative UK company accounts did not help: consolidated accounts (reporting the group’s overall position rather than individual companies within the group) were not compulsory until 1948, and even something as basic as turnover did not legally have to be disclosed until 1976. As a result you could find analysts in the same research note covering US stocks in an industry by looking mainly at their P/E, but the UK stocks in the same industry by mainly considering their DY.

It was not until 1965 that UK investors really caught up with the US in their use of valuation ratios. The introduction of corporation tax in that year meant that companies and individual shareholders were finally treated as separate taxable entities. Until then, companies had paid income tax on behalf of their investors, who might have to pay further tax depending on their level of income. Thus it was difficult to estimate company income after company taxes but before personal taxes. By 1966 The Economist was already valuing many UK companies using their P/Es.

The P/E today

Amongst practical investors the P/E has maintained its popularity since then. However, there are two areas in which the P/E has been eclipsed in recent years. Interest in it from finance academics has been limited since Eugene Fama and Ken French decided in the early 1990s that price-to-book value was a better indicator of value stocks and dropped the P/E from their now widely popular three factor model. (See later chapter.)

The other time the P/E has become little used has been during stock market bubbles. This is ironic considering that the P/E itself only came to prominence during the 1920s’ boom in the US. Some extraordinary P/E ratios occurred during the dot.com mania: America Online reached a P/E of 275 and Yahoo a P/E of 1900.

Extraordinary P/Es in the hundreds or thousands are telling investors that they are building castles in the sky, but during bubbles that is precisely the message that investors don’t want to hear.