Why do P/E ratios for a particular industry tend to cluster around particular values?
"This falls under value investing, and value investing has only recently picked up study by academia, say, at the turn of the millennium; therefore, there isn't much rigorous on value investing in academia, but it has started. However, we can describe valuations: In short, valuations are randomly distributed in a log-Variance Gamma fashion with some reason & nonsense mixed in. You can check for yourself on finviz.  You can basically download the entire US market and then some, with many financial and technical characteristics all in one spreadsheet. Re Fisher: He was tied for the best monetary economist of the 20th century and created the best price index, but as for stocks, he said this famous quote 12 days before the 1929 crash: ""Stock prices have reached what looks like a permanently high plateau. I do not feel there will be soon if ever a 50 or 60 point break from present levels, such as (bears) have predicted. I expect to see the stock market a good deal higher within a few months.""   - Irving Fisher, Ph.D. in economics, Oct. 17, 1929 EDIT Value investing has almost always been ignored by academia.  Irving Fisher and other proponents of it before it was codified by Graham in the mid 20th century certainly didn't help with comments like the above.  It was almost always believed that it was a sucker's game, ""the bigger sucker"" game to be more precise because value investors get destroyed during recession/collapses.  So even though a recessionless economy would allow value investors and everyone never to suffer spontaneous collapses, value investors are looked down upon by academia because of the inevitable yet nearly always transitory collapse.  This expresses that sentiment perfectly. It didn't help that Benjamin Graham didn't care about money so never reached the heights of Buffett who frequently alternates with Bill Gates as the richest person on the planet.  Buffett has given much credibility, and academia finally caught on around in 2000 or so after he was proven right about a pending tech collapse that nearly no one believed would happen; at least, that's where I begin seeing papers being published delving into value concepts.  If one looks harder, academia's even taken the torch and discovered some very useful tools. Yes, investment firms and fellow value investors kept up the information publishing, but they are not academics. The days of professors throwing darts at the stock listings and beating active managers despite most active managers losing to the market anyways really held back this side of academia until Buffett entered the fray and embarrassed them all with his club's performance, culminating in the Superinvestors article which is still relatively ignored.  Before that, it was the obsession with beta, the ratio of a security's variance to its covariance to the market, a now abandoned theory because it has been utterly discredited; the popularizers of beta have humorously embraced the P/B, not giving the satisfaction to Buffet by spurning the P/E.   Tiny technology firms receive ridiculous valuations because a long-surviving tiny tech firm usually doesn't stay small for long thus will grow at huge rates.  This is why any solvent and many insolvent tech firms receive large valuations: risk-adjusted, they should pay out huge on average.  Still, most fall by the wayside dead, and those 100 P/S valuations quickly crumble. Valuations are influenced by growth.  One can see this expressed more easily with a growing perpetuity: Where P is price, i is income, r is the rate of return, and g is the growth rate of i.  Rearranging, r looks like: Here, one can see that a higher P relative to i will dull the expected rate of return while a higher g will boost it. It's fun for us value investor/traders to say that the market is totally inefficient.  That's a stretch.  It's not perfectly inefficient, but it's efficient.  Valuations are clustered very tightly around the median, but there are mistakes that even us little guys can exploit and teach the smart money a lesson or two. If one were to look at a distribution of rs, one'd see that they're even more tightly packed.  So while it looks like P/Es are all over the place industry to industry, rs are much more well clustered. Tech, finance, and discretionaries frequently have higher growth rates so higher P/Es yet average rs.  Utilities and non-discretionaries have lower growth rates so lower P/Es yet average rs."
P/E can use various estimates in its calculation as one could speculate about future P/E rations and thus could determine a future valuation if one is prepared to say that the P/E should be X for a company. Course it is worth noting that if a company isn't generating positive earnings this can be a less than useful tool, e.g. Amazon in the 1990s lost money every quarter and thus would have had a N/A for a P/E. PEG would use P/E and earnings growth as a way to see if a stock is overvalued based on projected growth. If a company has a high P/E but has a high earnings growth rate then that may prove to be worth it. By using the growth rate, one can get a better idea of the context to that figure. Another way to gain context on P/E would be to look at industry averages that would often be found on Yahoo! Finance and other sites. Points are the units of measurement of the index. They're calculated based on the index formula, which in turn based on the prices of the underlying stocks. Movement in points is not really interesting, the movement as a percentage of the base price (daily opening, usually) is more interesting since it gives more context. "Yes, there are non-stock analogs to the Price/Earnings ratio. Rental properties have a Price/Rent ratio, which is analogous to stocks' Price/Revenue ratio.  With rental properties, the ""Cap Rate"" is analogous to the inverse of the Price/Earnings ratio of a company that has no long-term debt. Bonds have an interest rate.  Depending on whether you care about current dividends or potential income, the interest rate is analogous to either a stock's dividend rate or the inverse of the Price/Earnings ratio." In highly developed and competitive industries companies tread a continuous and very fine line between maximising shareholder profits by keeping prices up while making products as cheaply as possible, vs competitors lowering prices when they work out a way to make equivalents cheaper. In the short run you will quite often see companies hold onto large portions of efficiency savings (particularly if they make a major breakthrough in a specific manufacturing process etc) by holding old prices up, but in the long run competition pretty quickly lowers prices as the companies trying to keep high margins and prices get ruthlessly undercut by smaller competitors happy to make a bit less. While there are many very good and detailed answers to this question, there is one key term from finance that none of them used and that is Net Present Value. While this is a term generally associate with debt and assets, it also can be applied to the valuation models of a company's share price. The price of the share of a stock in a company represents the Net Present Value of all future cash flows of that company divided by the total number of shares outstanding. This is also the reason behind why the payment of dividends will cause the share price valuation to be less than its valuation if the company did not pay a dividend. That/those future outflows are factored into the NPV calculation, actually performed or implied, and results in a current valuation that is less than it would have been had that capital been retained. Unlike with a fixed income security, or even a variable rate debenture, it is difficult to predict what the future cashflows of a company will be, and how investors chose to value things as intangible as brand recognition, market penetration, and executive competence are often far more subjective that using 10 year libor rates to plug into a present value calculation for a floating rate bond of similar tenor. Opinion enters into the calculus and this is why you end up having a greater degree of price variance than you see in the fixed income markets. You have had situations where companies such as Amazon.com, Google, and Facebook had highly valued shares before they they ever posted a profit. That is because the analysis of the value of their intellectual properties or business models would, overtime provide a future value that was equivalent to their stock price at that time. Your analysis is correct.  The income statement from Google states that LinkedIn made $3.4 million in 2010 - the same number you backed into by using the P/E ratio.  As you point out, the company seems overvalued compared to other mature companies.  There are companies, however, that posts losses and still trade on exchanges for years.  How should these companies be valued?  As other posters have pointed out there are many different ways to value a company.  Some investors may be speculating on substantial growth.  Others may be speculating on IPO hype. Amazon did not make a profit until 2003.  Its stock had been around for years before that and even split many times.  If you bought the stock in 1998 and still have it you would be doing quite well. "P/E is a useful tool for evaluating the price of a company, but only in comparison to companies in similar industries, especially for industries with well-defined cash flows.  For example, if you compared Consolidated Edison (NYSE:ED) to Hawaiian Electric (NYSE:HE), you'll notice that HE has a significantly higher PE. All things being equal, that means that HE may be overpriced in comparison to ED. As an investor, you need to investigate further to determine whether that is true. HE is unique in that it is a utility that also operates a bank, so you need to take that into account. You need to think about what your goal is when you say that you are a ""conservative"" investor and look at the big picture, not a magic number. If conservative to you means capital preservation, you need to ensure that you are in investments that are diversified and appropriate. Given the interest rate situation in 2011, that means your bonds holding need to be in short-duration, high-quality securities. Equities should be weighted towards large cap, with smaller holdings of international or commodity-associated funds. Consider a target-date or blended fund like one of the Vanguard ""Life Strategy"" funds." The article is talking about relative cost. You could use the cash Schiller P/E ratio as a proxy. That's unit of price per unit of earning. The answer to your question is one time in history, during the 2000 dot com bubble. It's higher than 2008 before the downturn. You are paying more for the same earnings. That has nothing to do with the size of the economy and everything to do with interest rates being too low for too long "The ""random walk"" that you describe reflects the nature of the information flow about the value of a stock.  If the flow is just little bits of relatively unimportant information (including information about the broader market and the investor pool), you will get small and seemingly random moves, which may look like a meander.  If an important bit of information comes out, like a merger, you will see a large and immediate move, which may not look as random. However, the idea that small moves are a meander of search and discovery and large moves are immediate agreements is incorrect.  Both small moves and large moves are instantaneous agreements about the value of a stock in the form of a demand/supply equilibrium.  As a rule, neither is predictable from the point of view of a single investor, but they are not actually random.  They look different from each other only because of the size of the movement, not because of an underlying difference in how the consensus price is reached." "For any isolated equity market, its beta will less resemble the betas of all other interconnected equity markets.  For interconnected markets, beta is not well-dispersed, especially during a world expansion because richer nations have more wealth thus a dominant influence over smaller nations' equity markets causing a convergence.  If the world is in recession, or a country is in recession, all betas or the recessing country's beta will start to diverge, respectively.  If the world's economies diverge, their equity markets' betas will too.  If a country is having financial difficulty, its beta too will diverge. Beta is correlation against a ratio of variance, so variance or ""volatiliy"" is only half of that equation.  Correlation or ""direction"" is the other half.  The ratio of variance will give the magnitude of beta, and correlation will give the sign or ""direction"". Therefore, interconnected emerging equity markets should have higher beta magnitudes because they are more variant but should generally over time have signs that more closely resemble the rest.  A disconnected emerging equity market will improbably have average betas both by magnitude and direction." "To add on to the other answers, in asking why funds have different price points one might be asking why stocks aren't normalized so a unit price of $196 in one stock can be directly compared to the same price in another stock.  While this might not make sense with AAPL vs. GOOG (it would be like comparing apples to oranges, pun intended, not to mention how would two different companies ever come to such an agreement) it does seem like it would make more sense when tracking an index.  And in fact less agreement between different funds would be required as some ""natural"" price points exist such as dividing by 100 (like some S&P funds do). However, there are a couple of reasons why two different funds might price their shares of the same underlying index differently. Demand - If there are a lot of people wanting the issue, more shares might be issued at a lower price.  Or, there might be a lot of demand centered on a certain price range. Pricing - shares that are priced higher will find fewer buyers, because it makes it harder to buy round lots (100 shares at $100/share is $10,000 while at $10/share it's only $1000).  While not everyone buys stock in lots, it's important if you do anything with (standardized) options on the stock because they are always acting on lots.  In addition, even if you don't buy round lots a higher price makes it harder to buy in for a specific amount because each unit share has a greater chance to be further away from your target amount. Conversely, shares that are priced too low will also find fewer buyers, because some holders have minimum price requirements due to low price (e.g. penny) stocks tending to be more speculative and volatile. So, different funds tracking the same index might pick different price points to satisfy demand that is not being filled by other funds selling at a different price point." One problem is that P/E ratio only looks at the last announced earnings. Let's take your manufacturing plant with a P/E of 12.5. Then they announce a major problem that will hurt future earnings and the price drops in half. Now the P/E is 6.25. It looks great, but since there aren't any new earnings that reflect the problem, it's very misleading. "You can think of the situation as a kind of Nash equilibrium.  If ""the market"" values stock based on the value of the company, then from an individual point of view it makes sense to value stock the same way. As an illustration, imagine that stock prices were associated with the amount of precipitation at the company's location, rather than the assets of the company.  In this imaginary stock market, it would not benefit you to buy and sell stock according to the company's value.  Instead, you would profit most from buying and selling according to the weather, like everyone else.  (Whether this system — or the current one — would be stable in the long-term is another matter entirely.)" When fundamentals such as P/E make a stock look overpriced, analysts often point to other metrics. The PEG ratio, for example, can be applied to cast growth companies in a better light.  Fundamental analysis is highly subjective. For further discussion on the pitfalls of fundamentals, I suggest A Random Walk Down Wall Street by Burton Malkiel. I'm not in the business but I've always thought that Catalyst + industry context = market beating returns.  Meaning that if you know what an event means faster than everyone else you can make money.  Though I don't know how you'd express that in a report.  An example that comes to mind is when Japan announced they were forming a consortium, the largest in the world, to make LCD panel glass.  After that I got the heck of GLW though the stock price kept going up at the time.  It is like no one understood the implications.