What P/E can tell you about a stock, and what it can’t

If there’s one water cooler conversation that investors love to have, it’s whether stocks are expensive or cheap. Your argument will depend partly on your investment approach: If you’re growth-focused, the valuation metrics of a quickly expanding company may not look overly pricey to you if you think the business has a lot of potential. If you’re value-oriented, those same numbers might cause you to run as far away from the market as fast you can. 

But if you were able to have a socially distanced talk around the water cooler today, you and your debating partner would both be left scratching their heads. 

Over the last week, the S&P 500’s forward price-to-earnings ratio, one of the main figures that investors use to measure the expensiveness of the market, has climbed to levels not seen since April 2002, when the technology bubble was in mid-burst. At the time of writing this column, the market had a forward P/E of 22 times, according to S&P Capital IQ, despite the fact that the index is still down 16% from Feb. 19, 2020, when it reached its all-time price high. According to Factset, its P/E is also well above its historical five-year, 10-year, 15-year and 20-year averages, though it’s still below its March 2000 peak of 24.2. 

If you look at this metric, you’d think that the market is expensive. While the S&P 500 has climbed by 27% since Mar. 23, when stocks bottomed (or at least bottomed for now), it’s curious as to why its forward P/E ratio is hovering near record-breaking levels. 

Pay attention to P/E

Investors should have an understanding of the P/E ratio, as it’s often a good (though imperfect) starting point for people who want to determine a company or market’s priciness. The ratio, which is calculated by dividing a company’s share price by its predicted earnings per share, indicates what investors are willing to pay for every dollar of future earnings. If the S&P 500 is trading at 22 times earnings, then people are willing to pay $22 for $1 of earnings. (In March, people were willing to pay $14 for every $1 of earnings—so, much less than they’re paying now.) 

You can use a variety of P/E metrics, but forward P/E is the price people are willing to pay for future earnings as opposed to regular PE, which is the price the company is trading at right now. Investors tend to prefer using forward P/E, though the current PE is high, too, right now at about 23 times earnings. 

There’s no specific number that indicates expensiveness, but, typically, stocks with P/E ratios of below 15 are considered cheap, while stocks above about 18 are thought of as expensive. Depending on your view of the market, expensive isn’t necessarily bad. Amazon’s forward P/E ratio has constantly been in the 70s and 80s over the last year—it’s at 101 times earnings today—in part because people are happy to pay more for earnings if they think the stock price is going to continue climbing. (Amazon’s shares are up by 25% since January.) 

Many people like owning companies with lower P/E ratios because it could mean these companies have room to grow—usually, PE ratios rise along with stock prices—but it also protects on the downside, as cheaper businesses tend to fall less than more expensive ones during a market crash. Still, you don’t want to buy the cheapest companies. A P/E that’s much lower than the market or a company’s peers could be a sign that that business is in trouble. 

Falling earnings, higher P/E

Clearly, earnings are an important part of this equation. So, what does it mean when, in a time like this, analysts are forced to cut their Q2 earnings estimates for S&P 500 companies by a whopping 28.4%? It means that, all of the sudden, people are paying a lot more for a company’s future earnings. You would think that if earnings were expected to fall by nearly 30%, stocks would also fall by an ungodly amount, and then the market wouldn’t look so expensive. But, as I’ve written before, investors remain optimistic that the pandemic, and its economic effects, will be short-lived. 

 Normally, a 22 times P/E would cause consternation among many investors, but Bill Dye, head of Canadian equities at Vancouver’s Leith Wheeler Investment Counsel isn’t paying much attention to the metric these days. “When people say the market is expensive on 2020 earnings, those are depressed earnings,” he says. “That’s not a reasonable way to look at it.” He also says that if you look at where the S&P 500 is trading today, using 2019 earnings, the market would be trading at about 17.5 times earnings. 

Investors should look beyond this year and consider 2021 or 2022 earnings to get a more accurate view of the market’s valuation. “The market can look through this recession and say, ‘I’m going to put a multiple on the more normalized earnings we’ll see in the next few years,’” Dye says. If earnings do get back to last year’s levels, then a valuation of between 18 and 20 times may be more reasonable, he says. That’s still not cheap, but it’s at least closer to historical norms. 

The one problem is that it may be difficult to determine what kind of earnings the market, or a company, will have post-pandemic. Some businesses will rebound, some may post higher earnings and others will have trouble getting back to where they were. Investors can look at how a company fared during the last recession, or how well they were doing before COVID-19, to decide what sort of earnings they may have in a year or two, but not knowing what’s to come will make it difficult for investors to figure out whether the market, or the company they’re interested in, is cheap or expensive right now. 

Saying that, cyclical stocks look better from a valuation perspective than defensive stocks, which are typically more value-oriented, says Dye. In a recession, investors scoop up defensives, like grocery stores and other consumer staples, pushing their valuations higher. Cyclical companies, where fortunes can rise and fall based on the economic environment, tend to get hit hard, but then rebound during the recovery. “We’ve seen some cyclicals come back, but not much as people are still concerned about the outlook for the economy,” he says. “We’ll see that rotation, but it hasn’t happened yet.” 

Like everything in this pandemic, nothing makes a lot of sense, so if you think something is odd, like high market valuations, then dig a little deeper to find out more about what’s going on. You never want to base an investment decision only on P/E, but that’s especially true today. 

MORE BY BRYAN BORZYKOWSKI:

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