Here’s the thing: everyone throws around price-to-earnings like it’s the ultimate indicator. But Buffett’s approach cuts deeper, messier, and frankly, more honest. We’ve been handed a tool we’re told is universal, but what if it’s just a blunt instrument in the wrong hands?
Understanding the PE Ratio in Buffett’s Framework
The price-to-earnings ratio is simple on paper: divide a company’s stock price by its earnings per share. A $60 stock earning $3 annually? That’s a PE of 20. Textbook. Neat. Clean. But Buffett doesn’t care about neat. He cares about what’s behind the number. And that’s where most investors stop thinking. They see a PE of 15 and say, “Fairly valued.” He sees it and asks: “Are those earnings real? Sustainable? Unencumbered by debt or accounting tricks?”
Buffett’s View on Earnings Quality
Because not all earnings are created equal. A company can show $1 per share in profits, but if it needs to reinvest $0.90 just to maintain operations, the real economic return is thin. Buffett calls this “owner earnings”—a concept he introduced in the 1986 Berkshire Hathaway letter. It’s roughly net income plus depreciation, minus maintenance capital expenditures. It’s what you could theoretically pay out to owners without shrinking the business.
And that’s exactly where the standard GAAP earnings used in PE calculations fall short. They don’t account for how much cash the business must reinvest just to tread water. A utility might have stable earnings but require endless capital to keep the lights on. Tech firms? Often reinvest heavily in R&D. So comparing their PEs directly? Fool’s gold.
Why Buffett Ignores PE in Favor of Owner Earnings
Let’s take an example. In 1972, Berkshire bought See’s Candies for $25 million. The company earned about $4 million pretax—roughly $2.5 million after tax. That’s a PE of around 10. Sounds reasonable. But the magic wasn’t in the multiple. It was in the economics: See’s needed almost no reinvestment. Profits flowed to the owners. Over the next 50 years, those retained earnings were redeployed across Berkshire’s empire—into stocks, insurance, railroads. The initial “low” PE doesn’t capture that compounding engine. That’s why Buffett said, “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
The Danger of Blindly Following PE Ratios
But here's where it gets messy: the market loves simplicity. PE ratios are everywhere—on Yahoo Finance, CNBC tickers, brokerage dashboards. They’re fast food for investors. And like fast food, they’re cheap, easy, and often unsatisfying long-term. Buffett knows this. He’s seen companies with sky-high PEs collapse (looking at you, late-90s dot-coms), and others with “expensive” multiples keep rising for decades (Apple, anyone?).
When Low PE Signals Trouble, Not Opportunity
A low PE might seem like a bargain—until you realize the earnings are temporary. Think of a cyclical company at peak profits: an oil firm when crude hits $120/barrel. Earnings surge. PE drops. Investors pile in. Then prices fall. Profits vanish. The “cheap” stock becomes a value trap. Buffett avoids these like the plague. He’d rather wait for a durable business, even at a higher multiple.
Take Berkshire’s purchase of Precision Castparts in 2016. The PE was over 20—high for Buffett. But the company had dominant market share, high barriers to entry, and reliable cash flows. He overpaid by traditional metrics—and still wrote it down years later. Even Buffett misjudges. But his mistakes aren’t from chasing low PEs. They come from overestimating predictability.
The Problem With Comparing PEs Across Industries
You wouldn’t judge a bakery by the same standards as a software firm. Yet investors do this constantly. A SaaS company trading at PE 80 isn’t automatically overvalued. If it grows at 30% annually with minimal incremental cost, that multiple might be justified. A bank at PE 8? Could be a ticking time bomb if loan defaults rise. Buffett doesn’t compare apples to apples. He compares economic models. Return on equity, reinvestment needs, pricing power. The PE ratio shows up—maybe—but only after those are understood.
Buffett’s Alternatives to PE: What He Actually Uses
So what does he use instead? Not one tool. A toolkit. And the discounted cash flow (DCF) model tops the list. It’s not about next year’s earnings—it’s about the next 10, 20, even 30 years. How much cash will this business generate, adjusted for time and risk? Buffett simplifies it: “In order to value any business, you just need to estimate the future free cash flows and discount them back to the present.” Simple in theory. Brutal in practice.
Owner Earnings: Buffett’s Real Valuation Metric
He doesn’t trust reported earnings. He recalculates. Adds back non-cash charges. Subtracts real maintenance costs. Adjusts for working capital swings. What’s left? The cash that could be paid to owners. This figure—his version of free cash flow—is what he plugs into his mental DCF. A company earning $1 billion in GAAP profit but needing $800 million to sustain operations? Only $200 million is truly available. That changes the valuation dramatically.
The Role of Return on Equity and Business Durability
Buffett loves businesses with high and stable return on equity (ROE)—ideally above 15% for years. Why? Because high ROE means the company generates strong returns on capital without needing constant dilution. Think Coca-Cola: brand power, low production cost, global reach. ROE often above 40%. Even with a PE of 30 in the 1990s, it kept compounding. The multiple didn’t matter as much as the reinvestment power.
And that’s the hidden variable: durability. A high ROE today means nothing if competition erodes margins tomorrow. Buffett spends more time on moats—brand, cost advantages, network effects—than on quarterly earnings multiples.
PE Ratio vs. Other Metrics: A Reality Check
Let’s compare. PE ratio: fast, common, shallow. Price-to-book? Used by Buffett early in his Graham-influenced days. But book value is meaningless for asset-light firms like Google. EV/EBITDA? Popular with analysts, but ignores capex. Free cash flow yield? Closer to Buffett’s thinking—but still just a snapshot.
Free Cash Flow Yield vs. PE Ratio
A stock trading at $100 with $5 in earnings has a PE of 20. But if it generates $8 in free cash flow, the yield is 8%. That’s better than a 10-year Treasury at 4%. But if it only generates $2 in free cash flow? Then the 5% earnings yield is misleading. The cash flow yield tells a truer story. Buffett knows this. He’s said, “Cash is to a business as oxygen is to an individual: never noticed when it is present, the only thing in mind when it is absent.”
Why EBITDA Is a Dangerous Distraction
EBITDA—earnings before interest, taxes, depreciation, and amortization—has been called “bullshit earnings” for a reason. It ignores capex. A telecom might show $10 billion EBITDA but spend $8 billion keeping its network alive. Real profit? Maybe $1 billion. Yet analysts tout EBITDA multiples like gospel. Buffett mocks this. He knows depreciation isn’t “non-cash” in reality—it reflects real wear and tear. Ignoring it is like saying your car doesn’t lose value because you didn’t write a check today.
Frequently Asked Questions
Even seasoned investors get tripped up by Buffett’s nuanced take. These questions come up again and again.
Does Warren Buffett Ever Use the PE Ratio?
Yes—but cautiously. He’ll glance at it, especially when comparing similar businesses. But he never buys based on a low PE alone. In Berkshire’s 2000 letter, he noted: “Most analysts feel they must provide a target price and a 12-month earnings estimate. We feel no such compulsion. We focus on far longer time frames.” That said, he’s used PE as a sanity check. If a stock trades at PE 5 with strong fundamentals, he’ll investigate. But he won’t assume it’s a bargain.
What’s a “Good” PE Ratio According to Buffett?
There isn’t one. Seriously. He’s bought stocks with single-digit PEs (American Express in the 1960s) and avoided those in the teens (many tech firms in the 2000s). What matters is the long-term cash return. He once said, “Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.” But “marked down” doesn’t mean “low PE.” It means priced below intrinsic value—which he calculates via owner earnings, not GAAP.
Can You Apply Buffett’s Method Without Being a Pro?
You can try. But it’s not plug-and-play. You need to read financial statements, identify maintenance capex (buried in footnotes), estimate long-term growth, and apply a discount rate. Most investors don’t have the patience. And honestly, it is unclear if Buffett even uses formal DCF models—he says he does, but likely relies on mental approximations honed over 70 years. For the average person? Focus on what you can control: avoid overpriced stocks, buy companies with pricing power, and ignore quarterly PE chatter.
The Bottom Line
Warren Buffett doesn’t hate the PE ratio. He just doesn’t take it seriously as a standalone tool. It’s a starting point, not a finish line. The real insight isn’t in the formula—it’s in the mindset. Are the earnings real? Can they grow without heavy reinvestment? Is the business protected by a moat? Answer those, and the PE becomes background noise. I find this overrated: the obsession with mechanical metrics. Because numbers don’t lie—but they don’t tell the whole story, either. Buffett’s genius isn’t in crunching digits. It’s in seeing the business behind them. And that’s something no ratio can capture. (Though a good cup of coffee helps.)