This week, the market spooked a bit following the potential rise of the Covid-19 Delta variant. In this post, we’ll quickly walk through short-term bond market behavior before diving more deeply into our main topic: understanding how to read a price-to-earnings ratio.
Starting with the technical side of things, you’ll notice the bond market showed a safety trade last week — likely from the Delta variant and expectations of a possible lockdown again. As a result, Treasury yields on the 10-year have gotten down to 1.13, which is very low.
This graph also reflects the scared, cyclical side of the equity market. You can see week after week, mid and small-cap values continue to move lower, while large-cap growth remains at the top.
In summary: after an initial drop in the market due to fear, we’re starting to see it rebound.
Now, on to our main topic for today: Understanding the price-to-earnings ratio. We’ll discuss what it is, why it’s valuable, and how to identify a fair price-to-earnings — or P/E — ratio. The P/E ratio is calculated by dividing the market value price per share by the company’s earnings per share.
Since you’re dividing the price by earnings, the P/E ratio tells you exactly how many dollars you’re spending for each dollar of earning on the stock.
The main benefit of the price-to-earnings ratio is that it allows you to compare the prices of different stocks quickly and easily.
Now, let’s take this one step further. Research shows that stocks are worth the present value of the cash you could take out over the lifetime of the stock. So, just looking at the P/E ratio may not be enough. You also need to understand the stock’s cash flow behavior since, over the long-term, that’s what will drive stock performance. Finally, you must figure out a way to discount for the future value of those earnings.
How does that work? First, think of the valuation of cash flow for the S&P 500. When analysts calculate that valuation, they use both dividends and cash buybacks. So, you must project what both of those will be for your stocks to get your payout ratio. Then, you’ll divide that by your equity risk premium and a growth rate. How to Identify a Fair P/E Ratio
Let’s look at historical P/Es. In this chart, we see P/Es around the range of 16.5. Right now, we’re around 21.5. For reference, the average P/E for the S&P 500 has historically ranged from 13 to 15. To determine if a P/E ratio is fair, you should compare it to other stocks in the same industry, as well as relevant benchmarks.
We hear all the time from clients, “I don’t want to invest when P/Es are above average.” But if you’re afraid of high P/Es, you would only have had two chances to invest in the last five years: when the Fed tightened in 2018 and during Covid when P/E had fallen entirely, and the world was ending. If you didn’t invest during those times, you would have missed out on 22% returns in 2017, 30% in 2019, and 18% in the last two years.
Not only is it a bad strategy to assume, “High P/Es man we have to sell,” it also overlooks that high P/E can be an indicator that the market is thinking there’s going to be substantial growth in earnings. So, the reason you’re paying a higher P/E could be that analysts simply aren’t as bullish as the market.
What This Means for 2021
If we’re trying to set a price target for the end of the year, we need to look at where earnings will be. Then, to use a forward multiple, we need to see where our earnings will be at the end of next year. So, we use a consensus estimate (meaning an average of all analysts’ projections). The end of the year is about $191 on the S&P 500 in earnings. Looking out to the end of 2022, we see about a 12% growth rate to get $214 in earnings. So, we get a price objective target by the end of the year of 4,600.
This was a base scenario; let’s consider a bull and bear. In a bull scenario, we might say earnings grow at 15%, and the market does want to pay a higher multiple. Now, we’re starting to see a price target of $5,000, a 15% upside of where we are. In a bear market, we might see earnings coming down to 8% and pay a lower multiple with a downside of 10%.
For a full deep dive into P/E and current market behavior, be sure to watch our recap video below and on our YouTube channel. Of course, your GWS team is always available for questions, too!
For detailed performance metrics, please don’t hesitate to contact your lead advisor. And, in the meantime, be sure to keep up to date on Gatewood Wealth Solutions through our daily 3x3s and our weekly market insights on our YouTube, LinkedIn, and Facebook accounts.
Economic forecasts set forth may not develop as predicted, and there can be no guarantee that strategies promoted will be successful. Therefore, the opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
All performance references are historical and are no guarantee of future results. In addition, all indices are unmanaged and may not be invested directly.
Securities and advisory services are offered through LPL Financial, a registered investment advisor, Member FINRA/SIPC. All investing involves risk, including possible loss of principal. No strategy assures success or protects against loss.