Many investors are wondering if the rapid rise in the U.S. stock market is justified and if stocks are overvalued now. They know that to make money in stocks they must ‘buy low and sell high,’ so they are concerned about buying stocks at these higher levels. The price-earnings ratio is often used as a valuation tool. Today we take a look at that tool and how to use it.
The Price-Earnings Ratio, a Valuation Tool
Equity investors have several tools available to help them find the value of companies and stock markets. One of the more preferred methods is to discount future cash flows, though few investors have the time or resources to do this. Like most humans, equity investors prefer simple and effective tools like the price-earnings, or (P/E) ratio.
Focusing solely on one metric can result in a skewed perspective and wrong conclusions. Before we introduce other useful ratios and tools, let’s focus on the P/E ratio for a minute.
The price-earnings ratio, or P/E ratio, represents the multiple of earnings that an investor would pay to own a stock or stock index. For example, a stock with a P/E ratio of 22x means that an investor who buys that stock would pay 22 times the company’s annual earnings. This ratio can also be applied to a stock index or group of stocks. For example, an index with a P/E ratio of 18x means that an investor who buys that index would pay 18 times the annual earnings of all companies in the index, weighted according to their percentage in the index.
Sometimes you may see the P/E ratio stated as the ‘forward P/E ratio.’ Forward P/E ratios are based on the company or indexes earnings over the next 12 months, rather than for the trailing 12 months. Since forward P/E ratios are based on an estimate of earnings growth, they tend to be lower than the P/E ratio.
Comparing Stocks and Markets Using P/E Ratios
Let’s say you have some money to invest and have selected two stocks to consider. Stock A has a P/E ratio of 22.7x and Stock B’s P/E ratio is 15.1x. If you buy Stock A, you will pay $22.70 to buy $1 of current earnings. For Stock B, you would pay $15.10 to buy $1 of current earnings. If the two stocks were alike in all other ways (not very likely), a rational investor would prefer to pay less for $1 of earnings and would buy Stock B.
P/E ratios should be considered in context. Using the example above, Stock A may be growing its revenue and earnings, making its higher P/E ratio seem reasonable. Stock B may have seen its earnings drop over the last year or two, making it less of a bargain. External factors can also give context. If Stock A is more sensitive to interest rates than Stock B and interest rates are expected to remain low for a few years, Stock A may have a justified reason for a higher P/E ratio.
Recent Valuations of Regions Using P/E Ratios
When analyzing a country’s entire stock market, or a group of markets for a geographic region, investors can use the P/E ratio for that market or region. Using recent price and earnings data, the P/E ratio for the global stock market is about 19.8x. For U.S.-based investors, we usually split the global market into three parts: U.S., EAFE (the developed markets of Europe, Australia, the Far East), and Emerging Markets. The respective P/E ratios for these three markets are 22.7x, 17.7x and 15.1x. In other words, an investor would pay $22.70 to buy $1 of earnings in the U.S. and only $15.10 for $1 of earnings in emerging markets.
Some countries and regions have consistently higher or lower P/E ratios. For example, the U.S. tends to maintain P/E ratios that are higher than those for emerging markets. Since the economies of emerging markets have historically grown at a faster rate than the U.S., the discrepancy in P/E ratios is somewhat puzzling. One explanation could be that the U.S. economy, laws and political environment provide stability versus emerging markets.
A Better Tool for Comparing Indexes, The CAPE Ratio
Ideally, investors would like a P/E ratio that takes into consideration factors beyond price and earnings. Enter the CAPE ratio.
The CAPE ratio, or Cyclically Adjusted Price Earnings ratio, is calculated by dividing the price of a stock index by the average inflation-adjusted earnings of its component stocks over the past 10 years. Notice that we use 10 years of data to calculate the current CAPE ratio. This can reduce the effect of recent changes in monetary policy and other factors. Also, an inflation multiplier is often applied to each year’s earnings before dividing the total by 10 to get the average. This allows investors to more freely compare CAPE ratios across countries and regions because each country’s inflation rate history has been considered.
Using the CAPE Ratio to Value Countries and Regions
Several studies have examined CAPE ratios and expected returns. Historically for the S&P 500 in the U.S., when the CAPE ratio has been less than 10 (stocks are undervalued) returns for the following 10 years were over 16%. When the CAPE ratio was over 25, the following 10-year return was less than 4%.
For emerging market indexes, studies have shown that a CAPE ratio of between 10 and 15 is considered normal, while a ratio over 20 could indicate that the market is overvalued and could be due for a correction. Like the P/E ratio, the CAPE ratio should be considered in a broader context.
Recent CAPE Ratios for Countries and Regions
As of June 30, 2020, the CAPE ratio for the U.S. was 29.35x. Compared to the CAPE ratio for Russia, 8.21x, the U.S. seems overvalued. However, when an investor considers the size of the two economies, the breadth of industries, the protection of private property, and other factors, the U.S. may still be considered the preferred investment. A better way to evaluate a country’s market would be to compare the current CAPE ratio to its historical average. In the modern era, the mean for the U.S. is about 16.73x and the median is 15.79x.
A recent CAPE ratio for the emerging markets was 15.5x, about half of the U.S. ratio. Developed markets in Europe had a recent CAPE ratio of 16.3x.
The Two Key Takeaways: Diversification and Context
There are two important takeaways for investors looking for value in the global equity markets.
The most important takeaway is also one of the two ‘free lunches’ of investing: diversification. In the past few years, the correlations among major countries have fallen to their lowest levels in decades. This increases the benefits of being globally diversified. If stocks in the U.S. are overvalued, owning cheaper stocks in the emerging markets can reduce annual volatility and offer price appreciation potential.
The second takeaway is to evaluate P/E ratios in the context of the stock, country or region. Investors should examine the recent and expected earnings growth rates, inflation rates and monetary policies. Geopolitical or economic risk factors are also important to consider. P/E ratios can be more useful when evaluating companies in the same industry operating in the same markets. CAPE ratios can help normalize comparisons across countries, but context remains very important.
At Oasis Wealth Planning Advisors, we follow the wisdom of evidence-based investing that shows the benefits of global diversification of equities. We help our clients maintain a long-term perspective with their equity allocation so that the goal of growing their portfolio can be achieved.