The P/E Might Well Prove Mightier than the Pessimism

Price Earnings Ratios as gumball machine | Sheaff Brock Investment Advisors

The P/E Might Well Prove Mightier than the Pessimism

The price earnings ratio, known as the p/e ratio for short, is a useful way to evaluate the attractiveness of a company’s stock price compared to its current earnings per share.

If a company is reporting earnings per share of $2, and the stock is selling for $20 per share, the p/e ratio is 10. “One potential way to know when a sector or industry is overpriced is when the average p/e ratio of all of the companies in that sector or industry climb far above the historical average,” explains Josh Kennon in thebalance.com.

The P/E ratio can be used by investors to:

  • determine which industries and sectors are overpriced or underpriced
  • compare the prices of companies in the same area of the economy
  • judge the general sentiment in the stock market

It’s this last use that has come under recent discussion. “With stock indices close to all-time highs and unprecedented monetary stimulus in recent years, it is reasonable to ask whether the U.S. economy has reached a potentially dangerous phase of excessive financial exuberance and of overvaluation in the stock market in particular.” In other words, are P/E ratios “stretched” to the point of snapping back?

Earnings, we see from the chart shown below, are certainly at record highs.

S&P Operating Earnings per Share | yardeni.com

But, as Sheaff Brock Managing Director David Gilreath emphasizes in a recent Knowledge Builder webinar, high earnings do not mean Price Earnings Ratios are over-stretched. In fact, Gilreath points out, in every decade since the 1920’s, the average P/E ratio for the Standard and Poor’s 500 Index has been 17, precisely where we are today! 

“The standard way to investigate market valuation is to study the historic Price-to-Earnings ratio using reported earnings for the trailing twelve months,” writes Jill Mislinki in Advisor Perspectives, Inc. But looking at Yardeni.com’s chart of forward earnings, Gilreath explains, the S&P 500 earnings estimates of $174 x P/E of 17 = a Standard & Poor 500 level of 3,000!

The Price/Earnings might prove mightier than the pessimism!

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