Comparing a Market’s PE ratio across time

Comparing a Market’s PE ratio across time

Analysts and market strategists often compare the PE ratio of a market to its historical average to make judgments about whether the market is under or over valued.

Thus, a market which is trading at a PE ratio which is much higher than its historical norms is often considered to be over valued, whereas one that is trading at a ratio lower is considered under valued.

While reversion to historic norms remains a very strong force in financial markets, we should be cautious about drawing too strong a conclusion from such comparisons. As the fundamentals (interest rates, risk premiums, expected growth and payout) change over
time, the PE ratio will also change. Other things remaining equal, for instance, we would expect the following.

· An increase in interest rates should result in a higher cost of equity for the market and a lower PE ratio.
· A greater willingness to take risk on the part of investors will result in a lower risk premium for equity and a higher PE ratio across all stocks.
· An increase in expected growth in earnings across firms will result in a higher PE ratio for the market.
· An increase in the return on equity at firms will result in a higher payout ratio for any given growth rate (g = (1- Payout ratio)ROE) and a higher PE ratio for all firms.

In other words, it is difficult to draw conclusions about PE ratios without looking at these fundamentals. A more appropriate comparison is therefore not between PE ratios across time, but between the actual PE ratio and the predicted PE ratio based upon fundamentals
existing at that time.

http://zonecours.hec.ca/documents/A2009-1-1877347.ch18-earning-multiple(1).pdf