Understanding risk and return is essential in investing, and the P/E ratio is everywhere, but how do we tie them all together?
I was explaining the concept of the price-earnings ratio (P/E) to a friend of mine recently, and while she obviously grasped the mechanics of calculating the number, it was clear that the ratio had no real meaning for her.
Then I tried another approach. Instead of dividing the share price by the earnings per share (EPS) to give the P/E ratio, I did the opposite; I divided the EPS by the share price to calculate the 'earnings yield', the inverse of the P/E.
For example, a share that costs 100p, making a profit of 20p per share, has a P/E of 5 (i.e. 100/20). That may not mean much to some people, but when you say that it has an earnings yield of 20% (i.e. 20/100) it suddenly becomes easier to visualise along the same scale as a bank account or a loan.
Now we were making progress. The more risk you believe you're taking on, the more reward you'll require for taking the risk. That's why average earnings yields on shares are higher than the interest on corporate bonds. It's why corporate bonds don't pay as much as preference shares, but pay more than depositing your money in the bank.
And it's why Icelandic banks paid more interest than British banks -- it wasn't because paying out more money gave the bankers a warm feeling inside, it was because they were a riskier proposition and had to pay more interest to entice depositors away from supposedly safer banks.
But looking at one year's profits for a company is a rather crude measure, and the market will try to price in future prospects when arriving at a price. Even allowing for that, optimism and pessimism will often lose touch with reality. The irrational exuberance of the dot com boom is one example, and some would say the current gloom is another.
Either way, if you're trying to beat the market, you need to find investments that will pay more than you require for a given level of risk, assets that are mis-priced in your favour. You have to believe that the market has got it wrong, and ideally you need evidence to support that belief.
This is what hedge fund manager Michael Steinhardt calls 'variant perception'. To reject the consensus view in this way requires either better information than the market (which is more likely in the case of smaller companies which are frequently ignored by most fund managers), or a different view of how events will play out, meaning you weigh the risk factors differently from other investors.
So from flipping the P/E ratio on its head, my conversation with my friend got to the heart of contrarian investing in the space of 30 minutes. The next step, using that understanding to make money, is a much longer term challenge.
Why not check out Maynard Paton's variant perception as he attempts to beat the FTSE All-Share with his Champion Shares service. Or, if the challenge of beating the market is not your idea of fun, take a look at index trackers.
