Market Minute - March 3, 2017
by Scott Rosenquist, CFA
Market Valuation and P/E Ratio
The stock market has climbed double digits since the election and now has investors starting to wonder if it has moved too high too quickly. One of the most common measures of stock market valuation is the price to earnings ratio (P/E). When you hear in the news or from your neighbor that a stock looks cheap or expensive, they are most likely referring to the P/E ratio.
The P/E ratio is calculated by dividing the current market price by the earnings per share. This ratio can be calculated for an individual company or an entire market index such as the S&P 500. The P/E ratio can be a guage of investor sentiment on a stock or the entire market. The higher the P/E ratio, the more an investor is willing to pay for those earnings. Factors that drive this number may include the growth rate of those earnings and the risks associated with the specific company, sector, or index.
The P/E ratio is a relative valuation measure and should be compared to a similar investment or viewed historically. For example comparing Coca Cola’s P/E ratio relative to Pepsi makes sense since they operate in the same sector. You could also compare the P/E ratio to its own historical average. A current ratio below its historical average may indicate a stock is cheap compared to its own history.
As useful as the P/E ratio is, it is important to recognize its limitations. For example, earnings can be volatile for some companies or even negative, making the ratio difficult to interpret. Company management also has some discretion on accounting practices which can affect earnings. Earnings can also be distorted by events such as writing down losses or selling a portion of the business.
The S&P 500 is currently trading at a P/E of 24 compared to its long term average of 16. While this appears elevated, it is still below the levels seen in 1999 when it was above 30. The market is anticipating future growth, which is reflected by the increase in the P/E ratio as investors are willing to pay more for those potential earnings. In the next market minute I will discuss a popular alternative to earnings when considering valuation.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendation for any individual. Although general strategies and/or opinions are revealed, this post is not intended to nor does it represent or reflect transactions or activity specific to any one account. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All data and information is gathered from sources believed to be reliable and is not warranted to be correct, complete or accurate. Investments carry risk of loss including loss of principal. Past performance is never a guarantee of future results.