1/

Get a cup of coffee.

In this thread, I'll show you how the P/E ratio of a portfolio is related to the P/E ratios of its individual stocks.

The math here is beautiful. It involves harmonic means and a super elegant theorem known as the Cauchy-Schwarz Inequality.

2/

Earlier this week, I conducted a poll where I asked this question about P/E ratios.

Over 6,000 people responded.

Unfortunately, most of them got the answer wrong.

That's why I'm writing this thread. To (hopefully) correct some of the misconceptions that led people astray.

3/

To answer questions like this, it's always a good idea to go back to first principles.

In this case, we should ask ourselves: what exactly does a P/E ratio capture?

4/

We know that the P in P/E stands for Price. In other words, the amount we need to pay to acquire an asset today.

And the E stands for Earnings. The amount earned by our asset in the last 1 year.

5/

Note: P/E ratios come in more than 1 flavor.

For the E part, some people use earnings during the *last* 1 year. This is called the *trailing* P/E ratio.

Others use an estimate of earnings during the *next* 1 year. This is called the *forward* P/E ratio.