Does A High P/E Ratio Mean That The Stock Market Is Overvalued?

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01 Mar 2018

Price/Earnings Ratio (PE ratio)

What does a high PE ratio really mean? What is the significance of a high PE ratio and does it necessarily means a good chance to short a certain stock and make money?

The PE ratio we commonly use is trailing P/E:

It is obtained by taking the current price divided by the previous annual earnings. For the S&P 500, we take the price divided by the trailing earnings per share.
In short, Market Price ÷ Earnings Per Share
It gives us an idea of how much (in terms of multiples) are you paying for each dollar of earnings. For example, a PE ratio of 15 simply means you are willing to pay 15 dollars now for each dollar of previous earnings.

With Warren Buffet saying that “Buy when people are fearful, sell when people are greedy”. A PE ratio of 15 should be our golden ticket to becoming a billionaire, right?

Is this the indicator that we have all been waiting for? An indication of over-valuation?
The story is honestly not so simple.

If we decompose the equation, it works out to be like this:
Price of Share = Earnings X Earnings Multiples. Therein lies the problem!

We do not know current earnings/ forward earnings

Take, for example, a company’s previous year earnings are $1, and the share price is at 30.

This means that our trailing PE ratio is 30.

According to theory, such an indication would point out that the stock is “overvalued”. However, what if earnings results for this year comes out and we are looking at $5 in earnings? The market would then appear to be extremely cheap as the PE ratio would suddenly just be 6 times.

Hence, historical earnings may not be a good guide to future earnings simply because we are using past data. The best example that I can point to was during the financial crisis when earnings simply collapsed. The P/E of S&P 500 Index went to 70 with the price of S&P 500 Index at just 800.

Despite the market being at such elevated P/E was it really overvalued?

Also, forward earnings expectations may not be a sufficient guidance of the eventual “realized” earnings. They are after all just analyst expectations (which can be revised multiples times in a year as well).

Earnings multiples consider future expected earnings

Investors are pretty smart.

In general, people only pay up for huge earnings multiples if they think they can still make money. In other words, they are expecting earnings to climb even further, thereby compressing the eventual earnings yield.

Due to this discounting mechanism, it is not so straightforward to argue that the stock market is overvalued simply on the premise of the PE ratio.

The above is a chart of the S&P 500 along with its associated PE ratios. Ironically, the highest PE ratio to be found in this timeline was during the crisis when S&P 500 was at its lowest.

Perils of shorting bubbles: The market can be more irrational than you can be solvent

This famous quote from Keynes sums it up quite well. Even during the tech bubble famous fund manager Julian Robertson (Tiger Management) suffered huge losses from shorting the overvalued “tech” companies.

So how can we use P/E Ratios?

Personally, I believe that the PE ratios provides you a good framework to think about valuations.

If multiples are high, that indicates potential investor sentiments for an improvement in earnings.

If I believe that such materialization of earnings improvement is not incoming, then that would be a potential opportunity to go short, especially if I believe in a worsening of investor sentiment. For example, a situation when a fall in earnings alongside a fall in PE multiples to trigger a fall in the price.

The second way to look at the PE ratio is simply its inverse, which is the earnings yield of the S&P500. Through conversion to a yield format, we can then compare the equity yield against other assets, i.e fixed income to see which assets are more attractive.

Thus, for example, if the S&P500 yield works out to be 10% and the 10-year government bond yield is 15%, you can expect investor flows to prefer bonds (since the yield is higher and it is safer). This is also known as the FED model. I will talk more about this in another post.

Conclusion

At the end of the day, making money in public markets is extremely difficult. You are up against some of the most well-informed and trained professionals in the world. There are no easy short-cuts and while PE ratios may seem like a convenient way to think about valuations, there are much more nuances that we must take into account.