With the market at record highs, there is concern that the market is overvalued. If the market was a bubble in 2007, why aren’t we in a bubble today? The answer lies in a fundamental metric, the Price to Earnings (P/E) Ratio. This ratio measures the current share price of a stock and compares it to its per-share earnings. By looking at P/E ratios over time, you can determine if a company is trading above or below its historical average. If instead of looking at a company’s P/E ratio you look at the market’s overall P/E ratio, you can determine if the market is overvalued, undervalued or fairly valued.
When looking at P/E ratios, you need to know if you are looking at the trailing ratio (looking backwards over the past 12 months) or the forward ratio (looking forward to the next 12 months). The market always looks toward the future. Everyone knows what the facts are today. The goal of the market is to estimate where things are going 6 to 9 months in the future and price stocks today for that reality. While we do want to make sure that we aren’t getting ahead of ourselves, what we really care about is what the P/E ratio is expected to be in the future. That will tell us if stock prices today are overvalued or not. A good benchmark index for the market is the S&P 500. If we look at the P/E ratio of the S&P 500, we will have a good idea of the market’s valuation.
The historical mean for the trailing P/E of the S&P 500 is 15.50. The range is from 5.31 (in December 1917) to 123.79 (in May 2009). As of today, the current trailing P/E ratio of the S&P 500 is 18.85, a couple points above the historical mean. The forward 12 months P/E ratio for the S&P 500 is 16.05 based on analyst’s expectations for earnings growth next year. This means that if stock prices stayed constant and earnings increase as expected, the S&P 500 P/E ratio would drop to 16.05 in 12 months.
I’m not trying to claim that the market is cheap. What I am saying is that the market is not in bubble territory. The current trailing P/E ratio of 18.85 shows that the market is above it’s mean value and may by susceptible to a correction, but it is currently trading in it’s typical valuation range.