Warren Buffett is buying stocks today because he sees good value, not because he expects easy upside in the near future. It is this discipline search for value that has made Buffett the most legendary investor of all time. He recently made headlines with his $28 billion acquisition of H.J. Heinz with Brazilian partner 3G Capital at what many have observed was a full price above 20x earnings. But in Buffett’s words, he bought the company for its “terrific management” and a great partner for an investment he hopes to “own 100 years from now”.
This week’s chart illustrates the price to earnings ratio (PE ratio) from 1900 to present. As a general rule of thumb, when the PE ratio is high, stocks are considered to be expensive. Likewise, when the PE ratio is low, stocks look inexpensive. From 1900 up to the mid-1990s, the PE ratio tended to peak in the low to mid-20s (horizontal red line) and trough somewhere around seven (green line). The price investors were willing to pay for a dollar of earnings increased during the dot-com boom (late 1990s), surged even higher during the dot-com bust (early 2000s), and spiked to extraordinary levels during the recent financial crisis. Since the early 2000s, the PE ratio has been trending lower with the brief exception of the late 2008 period.
While the stock market has had been on quite a run over the past few years in bouncing back from the Great Recession, corporate earnings have also been growing or keeping pace with prices. There may be further market volatility later this year should the Eurozone troubles resurface or U.S. debt ceiling showdown heat up. But in the words of market sage Warren Buffett, stocks are a better value today than other investment options so long as you are willing to hold for the long term, you should buy.