The conversations on Valuepickr will improve if we have a better understanding of the term “valuation”. A company is under valued if over the long term, say ten years, it gives much better return than index. Similarly it is over valued if it performs badly when compared to index. Performance over long term is the key because, at the end of day, that is what an investor earns.
But, except for time travelers, nobody knows the future returns of the stock. Instead we use various heuristics to determine whether the stock is over or under valued. PE ratio is just one such heuristic. Mostly when people say a stock is overvalued, what they meant is stock has high PE ratio. I don’t believe it is a good heuristic. In general, it is unlikely that an easily computable metric like PE ratio will give an edge in market. People who still use PE ratio, should backtest it to see if it works.
Understanding that PE ratio is just a heuristic, frees your mind to consider other possible heuristics. In particular, you begin to look for value in good quality companies, which you would have otherwise ignored due to their high PE ratio. Wlamart in 1974 was a good example.
Wal-Mart’s 1974 Annual Report: Sometimes You Get What You Pay For | PHILOSOPHICAL ECONOMICS
It traded at twice the PE of index, but its long term returns were much superior to index. The most important takeaway is that for Walmart to be fairly valued, its PE should have been around 600. That’s an astronomical figure, especially in the era where index PE was just 6.9.
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