P/E is a financial statistic often quoted in the context of understanding the relative value of an individual company or the stock market as a whole and lately, it seems P/E figures are all over the map! The price to earnings ratio (often shortened as P/E) represents a company's stock price divided by the company's earnings per share.
A stock with a high P/E ratio suggests that investors are expecting higher earnings growth in the future compared to the overall industry or market. Investors are paying more for today's earnings in anticipation of future earnings growth. Conversely, a stock with a low P/E ratio suggests that investors have more modest expectations for its future growth compared to the industry or market as a whole.
Seems simple enough, but P/E figures you may see quoted in various financial publications aren't always the same. How can that be?
Types of P/E Ratios
First, there are different versions of the P/E ratio, depending on whether earnings are projected or realized, as well as the type of earnings.
- "Trailing P/E" sometimes called "Current P/E," uses the weighted average number of common shares divided by the net income for the most recent 12-month period. This is the most common meaning of P/E if no other qualifier is specified. The previous four quarterly earnings reports are used and earnings per share is updated quarterly. Note, each company chooses its own financial year so the timing of updates varies from one company to another.
The trailing P/E ratio for the S&P 500 was 26.66 at the close of business on Monday.
- Forward P/E" uses estimated net earnings over the next 12 months instead of net income. Estimates are typically derived as the mean of those published by a select group of analysts.
As of February month end, the forward P/E Ratio for the S&P 500 was 17.7.
- "Shiller P/E" is a price to earnings ratio based on average inflation-adjusted earnings from the previous 10 years. It's also known as the Cyclically Adjusted PE Ratio (CAPE Ratio) or PE 10.
The Shiller P/E ratio for the S&P 500 was
29.27
at the close of business on Monday.
Limitations of P/E
Aside from the various types of P/E, there is an important problem that arises with P/E valuations. The ratio's denominator (earnings per share or EPS) is based on accounting conventions that are susceptible to assumptions, interpretations and management manipulation. This means that the quality of the P/E ratio is only as good as the quality of the underlying earnings number.
It's not surprising that estimated EPS figures are often very optimistic during bull markets, while reflecting pessimism during bear markets. Also, the accuracy of stock analyst earnings estimates should be looked at skeptically by investors.
Current vs. Historical Valuations
Historically, the average P/E ratio for the broad market has been around 15, although it can fluctuate significantly depending on economic and market conditions. The ratio will also vary widely among different companies and industries.
The three ratios shown above tell us the market's P/E is 26.66 or 17.7 or 29.27, and technically all would be correct. But it's important to be aware of the differences as market commentators may pick and choose their statistic depending on the story they're trying to tell ("Stocks are way overpriced with P/E's of nearly 30 times!" Or, "Now is a good time to buy as stock valuations are barely above their long term average with P/E's of 17.")
Our view is that this bull market is in its ninth year and given the exhibits above, the market is definitely pricey.
Keep in mind though that P/E ratios, whether trailing, forward or Shiller, have been a poor guide to market timing.
Assuming forward P/E ratios are going to be 17x based on future earnings estimates is a bit like planning a wedding based on future weather forecasts. One can bet on that expectation but the downside can be huge!
