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What are your rules of thumb for PE ratios?

There are, of course, problems using PE ratios for valuation/margin of safety: they are not absolute values because they should vary depending on the level of interest rates (and/or the implied discount rate).

In teaching investing, I tried to use ratios that were easily accessible and understandable for ordinary investors. The method I arrived at was to relate the PE ratio of a stock to the average PE ratio for the market (which would relate to interest rates, but also the general level of valuation in the market). I adopted a guideline that for value model stocks, selecting stocks with a PE ratio significantly lower than the market average would afford a margin of safety. Of course, "significantly below" is a subjective judgement and reflects the nature of investment.

When I developed the growth model, it was immediately apparent that growth stocks could never be bought that cheaply because of the implied growth factor in their valuation. I therefore adopted the guideline for growth model stocks that the PE ratio should not be too far above the market average PE ratio. Again, this requires a subjective judgement.

Subjective judgements are difficult for investors who lack investment skills and experience. For them I have dumbed it down to: value model 10 PE and growth 15 PE.

In The Intelligent Investor, Graham did something similar for the defensive investor by suggesting a PE of 15, though he did not have two models, as I have.

In scanning for low PE stocks, I used a formula of the inverse of the bond rate + 50% risk premium. So, if the bond rate is 4%, the PE cut off would be 100/(4*1.5) = 16.7 PE. This appears high, and justifies high share prices, because of the low bond rate. So if the bond rate rises to 6%, the PE cut-off would fall to 11.1 PE. This demonstrates how sensitive stocks can be to interest rates and highlights the problem with the 10 and 15 guideline. 

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