The Price-Earnings Ratio: Understanding Historical and Current Trends
The price-earnings ratio (P/E ratio) is a widely used metric to determine the value of a company’s stock in the market. Since 1900, the average P/E ratio for the S&P 500 index has ranged from 4.78 in Dec 1920 to 44.20 in Dec 1999. However, except for some brief periods, during 1920–1990, the market P/E ratio was mostly between 10 and 20.
The average P/E of the market varies in relation to several factors, including the expected growth and stability of earnings, expected inflation, and yields of competing investments. For example, when U.S. treasury bonds yield high returns, investors pay less for a given earnings per share, and P/E ratios fall.
According to Jeremy Siegel, the average P/E ratio of about 15 (or earnings yield of about 6.6%) arises due to the long-term returns for stocks of about 6.8%. He suggests that with favorable developments like lower capital gains tax rates and transaction costs, a P/E ratio in the “low twenties” is sustainable, despite being higher than the historic average.
The recent year-end values of the S&P 500 index and the associated P/E ratios reported are set out below:
As the table shows, the P/E ratio of the S&P 500 index has fluctuated in recent years. In 2016 and 2017, the P/E ratio was relatively high, indicating that the market perceived companies as having higher risk or lower growth or both. However, in 2018 and 2019, the P/E ratio fell, indicating that the market perceived companies as having lower risk or higher growth or both. In 2020, the P/E ratio reached its highest level since the dot-com bubble of the late 1990s, as investors were willing to pay a premium for companies with high earnings growth potential during the pandemic. However, in 2021, the P/E ratio fell, as investors became more cautious about the potential impact of rising interest rates on the stock market.
Investors should also be aware that the P/E ratio is influenced by the industry in which a company operates. For example, companies in the technology industry typically have higher P/E ratios than companies in the consumer goods industry, as investors perceive the former as having higher growth potential.
In conclusion, understanding historical and current trends in the P/E ratio is essential for investors to make informed investment decisions. The P/E ratio is influenced by various factors, including the expected growth and stability of earnings, inflation, and yields of competing investments. Investors should use the P/E ratio in conjunction with other financial metrics and analysis to make informed investment decisions, and they should also be aware of industry-specific factors that impact the P/E ratio. Ultimately, investors should consider the P/E ratio in the context of a company’s financial history, future prospects, and industry trends to determine whether a stock is overvalued or undervalued in the market.
