When the Dow Jones Industrial Average is trading at 30,000, it’s very reasonable for investors to ask if the market is overpriced. How do we determine if an individual stock price is expensive, reasonable, or cheap? One measure is the price-to-earnings ratio. Let me explain.
Before jumping into the details, let’s make sure we’re on the same page. When investors talk about stocks being expensive or cheap, we are not just looking at the dollar price per share. On the surface, a stock price of $1,000 per share may seem expensive, while a stock trading at $10 per share may seem cheap. Unfortunately, the share price doesn’t tell you much about how the two companies should be valued. Those current stock prices need to be compared with other metrics to gauge whether each is cheap or expensive.
Owning a stock means having a claim of future earnings of the company. When buying a stock, you need to understand whether the price you are paying for that claim on earnings is appropriate. There are several different ways to measure this relationship.
The most commonly used method for comparison purposes is the price-to-earnings or P/E ratio. It relates share price to earnings per share and provides a means of comparison between companies as well as historical records. P/E can be measured a couple of ways:
- Forward P/Eis the current price divided by consensus analyst estimates of earnings per share for the next 12 months. Since estimates are involved, forward P/E is not an exact predictor of the future performance of a stock.
- Trailing P/Eis the current price divided by actual earnings per share over the past 12 months. Unfortunately, the COVID-19 pandemic may have impacted actual company earnings during 2020. In non-crisis times, trailing P/E can be a valuable tool for comparison. However, the current situation favors forward P/E to gauge where things stand in the future.
P/E Ratio as a Value Indicator
Let’s calculate the Forward P/E ratio for a hypothetical stock: If the price of XYZ stock is $50 and the earnings per share estimate is $2, then the P/E ratio is 25. If the earnings estimate is $4 per share, the P/E ratio for XYZ Company is 12.5. Considering only the P/E ratio, the lower the P/E ratio of the stock being purchased, the better the deal for an investor.
However, the P/E ratio by itself does not tell us if the stock is expensive or cheap. We need something to compare it to, such as the Forward P/E ratio of the S&P 500 Index.
As of March 31, 2021, the S&P 500 Index had a P/E ratio of 21.88. This means the 500 stocks represented in the S&P were trading, on average, at a multiple of 21.88 times the future earnings estimates. The 25-year average is 16.64! Based on this long-term average, the current price of the S&P 500 stocks would be considered expensive. The last time the S&P 500 P/E ratio was over 20 was in the late 1990s and early 2000s, a.k.a the dot-com bubble that ultimately burst!
If we compare XYZ Company’s P/E ratio of 25 to the long-term average, we would conclude that the stock is very expensive. However, the second calculation of the P/E ratio at 12.5 suggests that the price of XYZ stock with $4 per share earnings would be considered relatively cheap.
Factors Favoring Higher Valuations
With the current P/E ratio for the S&P 500 Index at 21.88 (130% of the long-term average P/E), what are investors to think? Do we find ourselves in another bubble that is about to burst?
There are a couple of arguments that suggest current valuations do not necessarily signal an overheated bull run:
- Continued earnings growth. We are now beginning to see the light at the end of the COVID-19 tunnel, which leads to a widespread belief that there is pent-up demand that will show up once the economy fully re-opens. If so, earnings are likely to grow quickly in the year ahead, leading to some compression in these ratios.
- Low-Interest Rates. A low-interest environment creates difficulty to find yield in fixed income. Combined with a low cost of borrowing for companies looking to finance new projects, this creates a more appealing environment for investors to justify some elevation of equity valuations above their historical averages.
Investors need to consider the current environment when managing their return expectations in the coming years. If you are becoming concerned about higher valuations and fear a downturn, a strategy to consider is becoming more defensive with your equity allocations. Be careful to avoid market timing and making changes that could harm your long-term strategy.
Ask your advisor how you can protect yourself from market downturns while participating in the potential earnings boost of a fully re-opened economy.
Anthony Harcourt is a Portfolio Manager at Bedel Financial Consulting Inc., a wealth management firm located in Indianapolis. For more information, visit their website at www.BedelFinancial.com or email Anthony at firstname.lastname@example.org.