Q. Why do you caution against using a popular measure, the price/earnings ratio, to value the market or individual companies? A: My answer to this question has a very unusual source of inspiration: slime mold. As it turns out,...
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Q. Why do you caution against using a popular measure, the price/earnings ratio, to value the market or individual companies? A: My answer to this question has a very unusual source of inspiration: slime mold. As it turns out, when food is abundant, slime mold cells operate as independent, single-celled units. But when food supplies are short, the cells converge into a large cluster. Whether slime mold is an "it" or a "they" depends on the circumstances. Good theory is about developing reliable links between cause and effect. Too often, theory is based on a system's attributes. In investing, for example, you might say that buying companies with low price/earnings ratios is good. In fact, many investment firms organize their activities around attributes. But really robust theory relies on circumstances. Whether a low price/earnings ratio is attractive depends on the circumstances. And since the underlying drivers of value change—think of fluctuating inflation expectations and tax rates—the appropriate price/earnings ratio changes with it.
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