The Price-to-Earnings Ratio
The most basic and fundamental yardstick for valuing stocks is the PE ratio. It is simply the ratio of the price of a share of stock to the annual EPS and measures how much an investor is willing to pay for a dollar's worth of current earnings.
The single most important variable determining the PE ratio of an individual stock is the expectation of future earnings growth.
If investors believe that earnings growth is going to accelerate, they will pay a higher price relative to current earnings than if they expect earnings to stagnate or decline.
However, earnings growth is not the only variable influencing the PE ratio. PE ratio are also influenced by other factors such as:
- interest rates,
- risk attitudes of investors,
- taxes, and
- liquidity among others.
Market PE Ratio
The PE of the entire Market =
Total market value of all stocks / aggregate earnings of all stocks
The historical average value of Market PE since 1870 is 14.5.
High Market PE due to drop in Earnings
Peaks in the Market PE ratio are not always bad omens for investors.
If a sharp drop in earnings cause the PE ratio to spike upward, such as occurred in the 1894, 1921, 1938, and 1990 - 1991 recessions, real returns following these spikes have averaged a robust 9.7% annually over the subsequent 5 years.
These returns are high because sharp declines in earnings always have been temporary, caused by recession or other special circumstances, and earnings as well as stock prices have rebounded subsequently.
Nevertheless, the PE ratio associated with the 2000-2001 recession is so high that investors should not expect above average returns to prevail.
High Market PE due to High Stock Prices
When surges in stock prices cause Market PE ratios to rise, as occurred in September 1929, July 1933, June 1946, November 1961, and August 1987, 5-year future real returns have averaged only 1.1%.
Surging stock prices often reflect undue optimism about future earnings growth. When faster earnings growth is not realized, stock prices fall, and returns suffer.
Certainly the Market PE spike that occurred in late 1999 and early 2000 accurately foretold poor future returns.
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