The Shiller P/E Ratio is one tool aimed at valuing stock picks, but it can be misleading when viewed in isolation

Price/earnings ratios may seem like the key to whether a stock is undervalued or overvalued because they receive so much attention in brokerage and media reports. But like any other single factor, an attractive P/E should encourage you to look more closely, to see if it gives you an accurate or misleading indication of the stock’s value.

The Shiller P/E ratio is an updated version of this tool, but it has its limitations.

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The Shiller P/E ratio is an example of a single idea that’s in fashion with investors, but out of tune with the current investment situation

The Shiller P/E ratio is the creation of author, economist and Yale University professor Robert Shiller. He used this ratio in his 2000 best-selling book, Irrational Exuberance. In that book, which came out within a month of the peak of the dot-com boom, Mr. Shiller showed how the ratio supported his view that stocks at that time were extremely overpriced. The timing of the book’s debut turned out to be perfect; the stock market began to swoon as soon as the book went on sale.

Mr. Shiller followed up with a 2005 edition of the book that applied a similar ratio to housing, comparing housing costs and individual incomes. He concluded that the U.S. was headed for a plunge in housing prices, which was just then getting underway.

The second book cemented Shiller’s reputation among academics and investment professionals. However, he became more widely known after being named a co-winner of the 2013 Nobel Prize in economics. This of course helped turn his Shiller P/E ratio into a household term, at least in investing households.

P/E ratios and interest

All p/e ratios tend to be inversely related to interest rates. When interest rates are low, and they are still low today, p/e’s tend to be high.

Mr. Shiller benefitted from extraordinarily fortunate timing for the publication of his two books. However, both works contained views he held during the several years when he wrote the books and got them published. Shiller himself believes, as we do, that nobody can consistently predict future stock price trends.

The term “irrational exuberance” comes from a speech that Alan Greenspan gave in October 1996, when he was Chairman of the U.S. Federal Reserve Board. Mr. Greenspan used the term to describe his view of the stock market at that time. He felt it had gone up out of all proportion to the economic situation. Many economists agreed. However, the market kept on rising for nearly four more years.

It’s always a bad idea to base your investment outlook on any one indicator or tool. It’s a particularly bad idea to base your outlook on a single idea that is in fashion with investors, but out of tune with the current investment situation.

The Shiller P/E ratio and the original p/e

The conventional per-share price-to-earnings ratio compares a stock’s price to its per-share earnings in a given year. It comes in two broad types. One concerns earnings estimates. This kind of p/e compares the current stock price to an estimate of future earnings—usually the current fiscal year, or the one after that. The other kind compares the current price to historical earnings—usually the last fiscal year, or the sum of the latest four fiscal quarters.

The Shiller P/E is a specialized tool—one that’s uniquely suited to rattle today’s investors. That’s because it uses current stock prices as its “P,” but takes the average figure of the past 10 years as its “E” or earnings.

The old-fashioned P/E ratios use earnings of the year just completed, or predictions for the coming year. There’s a big difference, but especially now.

The Shiller version provides a particularly misleading basis for comparison. After all, we’re in a 10-year span that includes the depressed “E” of the 2008/2009 financial crisis. This was the worst financial crisis in 70 years or more. When E is depressed, P/E goes up.

The Shiller P/E will come down naturally when the depressed 2008 and 2009 earnings get dropped from the calculation and replaced by 2018 and 2019 earnings.

High p/e’s can be profitable, too

You should expect to pay high p/e’s for stocks with lots of growth potential. As well, you may want to buy shares of high-p/e firms that report earnings even in bad times. This shows a high-quality company. This is true even if a company stays marginally profitable, or avoids eye-catching losses, in bad times.

You’ll also pay more for companies with a long-term earnings pattern. However, few are worth more than 20 to 25 times normal earnings in the midst of an economic cycle. So you should avoid loading your portfolio up with high-p/e stocks. Should the market go into a broad setback, these stocks are particularly vulnerable.

How have you used the Shiller p/e ratio to benefit your investing career?

Do you find the Shiller p/e ratio useful  in your investment decisions, or does it just create unhelpful information?