The P/E Might Well Prove Mightier than the PessimismSheaff Briefs Editor
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.
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!