Explaining PE Ratios

I was probably a bit technical in my previous post.

The way to value a stock is the ratio of its price to the earnings of the company. Theoretically each shareholder will receive some return based on the earnings of the company – either the company pays a dividend or the company reinvests profits into the company, making the company more valuable, increasing the potential for some future, larger dividend stream. And sometimes a company is sold and shareholders are sent checks. So to determine how much the share of stock is worth to you, you decide what multiple – how many times the company’s earnings – you are willing to pay to hold onto the share. That multiple is called the PE Ratio, which means the ratio of the price of a share to the company’s earnings per share.

Historically the stock market goes through cycles of people being willing to pay higher multiples and lower multiples, and over time you see clear patterns. Stocks go through periods where people want to buy stocks and are willing to pay more for them, and the average PE ratios increase. Then something happens and people decide that stocks have less general value than they thought, so they sell stocks, and the prices of stocks decrease, until people decide that stocks are a good deal and start buying them again. Over time you can see a pattern of how high PE ratios can get before people start selling, and how low they can get before people start buying. Historically the average is about 15 or 16.

Stocks are seriously overvalued! Look at the charts referenced below to see where the stock market PEs are now, compared to history. Today the PE ratio of the S&P 500 is 24.6. If you look at historical charts of PE ratios, you’ll see that the cycles range from a high of a little over 20 (except this time) and then fall (a “bear market”) to a low of under 10 (often well under 10) before they start a new rising cycle (a “bull market”). Currently stock PE ratios are well above historical highs! I think the PE of the stock market just before the 1929 crash was 21. (Remember, it’s a cycle, stocks fall below the historical R of about 15 before they start to rise again.) And all this is calculated using the earning as reported by the companies in the last few years. That includes companies like Enron and WorldCom. As we now know, they were inflating their earnings.

Core Earnings Standard & Poors has a new way to calculate earnings, called Core Earnings. Core Earnings don’t use any of the bullshit that companies like Enron were using. This document explains Core Earnings, and says that for the 12 months ending June, 2002, Core Earnings for the S&P 500 were $18.48 per share. Compare that to the “As Reported” earnings of $26.74 per share, and think about what this means for current PE ratios. Current PE ratios are calculated using “As Reported.” So using Core Earnings the current PE is closer to 50. (It is important to remember, the historical charts referenced here use “As Reported” earnings, so you can’t compare current Core Earnings PE ratios, except to the point that you think companies were inflating earnings in the last few years and whether you think they were doing more of this than was done historically. If you think they were doing more of this in recent times, than historical “As Reported” PE ratios would likely be closer to current Core Earnings.)

Charts. I’m linking here to a few charts showing the ratio of stock prices to the earnings-per-share, not the price of the stock, so there is no need to adjust for inflation, etc. They show you where stocks are valued at different points in the cycles.

Take a look at these charts and decide for yourself whether stocks are priced where they should be, underpriced, overpriced, way overpriced, way seriously overpriced, dangerously seriously overpriced, or hairy sweaty steaming grunting screaming indubitably massively terrifyingly holy-shit way-momma uglified oh-my-god end-of-the-world overpriced. (I describe, you decide.)

Here is a chart showing the range of PE valuations (calculated various ways) for 100 years (ending 2001).

Here is a chart of PE ratios (also calculated various ways) from 1929 to 2001.

These charts (PDF – see page 2) also show where the stock market is now, relative to history.

Here is another chart of historical PE ratios.