Over the past couple of years, the S&P 500 Forward P/E ratio has been above its 25-year average. This has led some market commentators to warn that equities aren’t attractively valued.
A Price to Earnings (P/E) ratio is a valuation measure that shows how much investors are willing to pay for a dollar of a company’s earnings. For example, a company that has a stock price of $30 and earnings per share of $2 would have a P/E ratio of 15 ($30/$2 = 15). A reading above the long-term average is typically interpreted to mean that stocks are expensive relative to the historical average. Similarly, a reading below the long-term average is typically interpreted to mean that stocks are cheap relative to the historical average.
The recent pullback in equities to start the year coupled with continued strong earnings growth has left the S&P 500 Forward P/E ratio at 16.1x at the end of April 2018. The 25-year average S&P 500 Forward P/E ratio is exactly 16.1x. This marks the first time in over 2 years that this reading has not been above the 25-year average.
In the current economic environment with low interest rates and low inflation, a forward P/E ratio that is equal to the 25-year average may actually be a signal that stocks are attractively valued.
Interest rates represent an investor’s opportunity cost for buying stocks. In other words, if a safe investment such as a Treasury offers a very attractive yield such as, say 7%, stock prices have to be attractively valued to entice investors to give up their safe 7% yield and take on the additional risk and volatility of an equity investment. Despite interest rates creeping up to start the year, interest rates are still below their long-term average.
Just like higher interest rates can make stocks less attractive, lower interest rates can make stocks more attractive and justify a higher P/E ratio than the long-term average. Investors may be more willing to pay a premium to own equities if the alternative is to get a low yield from a Treasury investment.
Likewise, a low inflation rate could justify a higher P/E ratio than average. If inflation is low, there is greater opportunity for higher real earnings growth. In other words, earnings growth of 5% is more beneficial to shareholders when inflation is 2% than it is when inflation is 5%. The higher the inflation rate, the more of that earnings growth gets lost to inflation. Investors are more willing to pay a premium in the form of higher multiples when they are receiving real earnings growth and not just increases in nominal earnings caused by inflation.
In the current environment of low interest rates and low inflation, a P/E ratio that is exactly equal to the 25-year average may actually indicate that stocks are currently undervalued. Low interest rates and tepid inflation can justify maintaining a valuation multiple above the historical average.
This all, of course, doesn’t mean that individual stocks or even individual sectors may be overpriced. To avoid the risks associated with purchasing an individual holding that is overvalued, it makes sense for investors to have a diversified portfolio of equities to minimize company specific risk.
Valuation metrics have not necessarily been a good predictor of short-term returns. It is certainly possible that stocks could have a negative return for the remainder of the year. However, forward P/E returning to its long-term average should provide at least some assurances for any investor who is nervous about valuations.