Many investors closely follow the price-to-earnings (P/E) ratio. They believe this tool allows them to determine whether an individual stock or the entire stock market offers value. The general interpretation is that low P/E ratios are found in cheap stocks that offer the greatest potential. A high P/E ratio, on the other hand, indicates the stock is potentially overvalued and is unlikely to deliver gains that are better than average.
This is a simple idea. Like many simple ideas related to the stock market, especially ideas that are widely followed, this one does not work very well.
The first problem we face when using the P/E ratio is defining the “E” or deciding which earnings to use. This makes a big difference in the level of the ratio. For the S&P 500, for example, we could use GAAP earnings, as reported earnings or forward earnings. The same is true for any individual stock as well.
GAAP stands for generally accepted accounting principles. These are rules that are agreed upon and companies are required to follow those rules when calculating earnings. This is believed by some to limit the potential for mischief. By following GAAP, management is still required to make a number of assumptions. Management must decide when and how revenue should be recognized, whether a cash outlay should be expenses or capitalized, how to manage late payments from customers and a variety of other issues. Although GAAP is a standardized framework, there is room for different opinions. Management can be aggressive or conservative or even creative under GAAP.
Many companies also provide adjusted earnings. Often called “as reported earnings” this number is adjusted by management to better reflect what management believes is important. As reported earnings may ignore the impact of stock options used for compensation, costs associated with acquisitions or layoffs and other expenses. While some investors consider as reported earnings to be less reliable. However, management is still required to be truthful and believes they are adding important information by adjusting earnings.
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Forward earnings are based on analysts’ estimated earnings for the next twelve months. Some investors prefer this measure because they reason that stock market investors are forward looking. The current price of a stock reflects the future prospects of a company. By ignoring past earnings, they may be properly pricing the market based on the future. Of course, most companies report earnings that are significantly better or worse than analysts’ expectations.
The P/E ratio based on the different earnings will be different. In May 2017, the P/E ratio based on GAAP earnings is 23.7. Based on adjusted earnings, the P/E ratio is only 21.4. Based on forward earnings, the P/E ratio is 17.5.
Many investors believe an average P/E ratio should be 15 to 17, depending on which years they use to calculate the average. No matter which average is used, the market appears to be overvalued at this time.
This simple indicator ignores an important question. Instead of asking what the average historic P/E ratio has been, investors should be asking what the P/E ratio should be. At any given time, the P/E ratio should be higher or lower than average based on interest rates.
Bonds can be considered an alternative to stocks by some investors. For example, if the 10-year Treasury note offered a yield of 20%, many investors would lock in the high yield and ignore the stock market. If that note carried a negative yield of 5%, many investors would invest new money in stocks rather than accept a guaranteed loss. This extreme example demonstrates the competition between the two asset classes for new investment dollars.
Ben Graham, Warren Buffett’s business school professor, quantified the relationship using the earnings yield. The earnings yield is the inverse of the P/E ratio, or the E/P ratio. The earnings yield defines the return on an investment an owner of the company would receive. Since shareholders are the owners of the company, it makes sense to look at the E/P ratio when making investment decisions.
Since stocks and bonds are alternative investments, it makes sense to assume a majority of investors will select stocks when the E/P ratio is higher than the interest rate. When interest rates are higher than the E/P ratio, money should flow to bonds instead of stocks.
Using this relationship, we can define the expected P/E ratio as the inverse of the 10-year yield. This means if 10-year notes yield 10%, we would expect stocks to trade with an average P/E ratio of 10 (1 divided by 1%). If interest rates fall to 5%, the P/E ratio should increase to 20. At a 1% interest rate, stocks could be fairly valued with a P/E ratio of 100.
Now that we are looking at the P/E ratio as dynamic, overvaluation looks different. Let’s look at some past bear markets.
The table below shows bear markets since 1966. The P/E ratio is based on GAAP earnings since that is what most historic earnings data is based on. The expected P/E is the inverse of the 10-year yield. The actual P/E to expected ratio is considered overvalued when it is above 1.0 and undervalued below 1.0. This is not a perfect indicator but is useful.Let’s look at the low P/E ratio in 1980 to understand the table a little better.
The bear market that began in 1980 began when the P/E ratio was 9.5. This was below average but was above the P/E ratio we should expect based on the 10-year yield of 12.7%. The ratio of actual P/E ratio to expected P/E ratio was 1.2 at that time, indicating the market was about 20% overvalued even though the P/E ratio was low based on historic averages.
This indicator isn’t perfect, as we noted. But, it has a surprisingly strong correlation with bear markets. Right now, it is telling us we should ignore the P/E ratio. This is true no matter which earnings numbers are used to calculate the ratio.
The important point from this chart is that the P/E ratio may seem high based on its absolute value, but when we consider interest rates the P/E ratio is actually rather low. As long as rates remain low, fundamentals support higher prices.
For 2017, Standard & Poor’s expects earnings per share for the S&P 500 to come in near $129. With a P/E ratio of 40, that provides a price target of 5,160, more than double the current level. This analysis ignores the fact that the Federal Reserve is raising rates. If rates move up by 1%, the price target for the S&P 500 falls to about 3,400.
These price targets assume interest rates are the only factor affecting stock prices. There are always other factors. In the current market, news about tax reform is a significant driver of the market action. It will be important to follow this story rather than just watching interest rates.
But, it will be equally important to ignore the reports of the market’s overvaluation. The market as a whole is undervalued based on interest rates. Many individual companies are undervalued based on their growth prospects. There are many investment opportunities in the current market despite the fact the market is trading at a high P/E ratio.