Warren Buffett: Should You Invest in a Stock With a High P/E Ratio?

Olympic diving and Olympic diving. You know they have a degree of difficulty factor, and if you can do some very difficult dive, the payoff is greater if you do it well than if you do some very simple dive. That's not true in investments. You get paid just as well for the most simple dive, as long as you execute it all right. There's no reason to try those three and a halves when you get paid just as well for just diving off the side of the pool and going in cleanly.

Thanks for the beautiful, beautiful weekend in Omaha. I'm Mike Asayle from New York City with a question for Warren and Charlie about what makes a company's price earnings ratio move up relative to other companies in its industry. How can we as investors find company and even industries that will grow their relative price earnings ratios as well as their earnings? And thank you for the wonderful weekend and for sharing your brilliance with the shareholders.

Thank you, thank you. You know, it's very simple that price earnings ratios, relative price earnings ratios, move up because people expect either the industry or the company's prospects to be better relative to all other securities than they have been, than their preceding view. That can turn out to be justified or otherwise.

Absolute price earnings ratios move up in respect to the earning power of the prospective earning power of that is viewed by the investing public, of returns on equity and also in response to changes in interest rates. In the recent, well really since 1982, but accentuated in recent years, you've had decreasing interest rates pushing up stocks in aggregate, and you've had an increase in corporate profits. Return on equity of American businesses improved dramatically recently, and that also, and people are starting to believe it. So that has pushed up absolute price earnings ratios.

Then, within that universe of all stocks, when people get more enthusiastic about a specific business or a specific industry, they will push up the relative PE ratio for that stock or industry.

Charlie: Yes, I think he also asks how do you forecast these improvements in price earnings ratios? That's your part of the question around here. I would say that if our predictions have been a little better than other people's, it's because we tried to make fewer of them. We also try not to do anything difficult, which ties in with that.

We really do feel that it's— you get paid just as well. You know, this is not like Olympic diving. In Olympic diving, you know they have a degree of difficulty factor, and if you can do some very difficult dive, the payoff is greater if you do it well than if you do some very simple dive. That's not true in investments. You get paid just as well for the most simple dive as long as you execute it all right.

There's no reason to try those three and a halves when you get paid just as well for diving off the side of the pool and going in cleanly. So we looked for one-foot bars to step over rather than seven-foot or eight-foot bars to try and set some Olympic record by jumping over. It’s very nice because you get paid just as well for the one-foot bars.