The problems with PE

I was startled last week to see the S&P 500 Price to Earnings ratio (PE) had passed 40. Although we rarely look at aggregate numbers, preferring to focus on individual companies, the figure nonetheless seemed high given our portfolio companies, some of the largest constituents of the index, are still under-valued.

As you can see below, while the trailing PE (blue line) is high, the forward PE (red line) is significantly lower, reflecting the expected growth in earnings in the year ahead. This divergence, resulting from the pandemic recovery, provides an opportunity to examine the inadequacy of the PE ratio.

What drives the PE

Price must increase relative to earnings for the PE ratio to climb. If price increases and earnings are flat the PE will go up. Similarly, if prices are flat but earnings decrease, it will also go up. The current PE is a combination of both these effects i.e. stock prices have increased and earnings have declined.

How earnings are assessed is important

The headline PE number uses trailing earnings, from the previous 12 months of operations. The problem is prices normally reflect investors’ future expectations for earnings, not past, and the current climate has exacerbated this issue. Trailing earnings were significantly impacted by Covid-19, but the market expects a strong rebound this year, so prices are high.

To adjust for this, investors should look at the forward PE which uses analysts’ expectations for future earnings. As noted above, the forward PE (red line) is significantly lower than the trailing PE (blue line) reflecting the expected growth in earnings in the year ahead.  

Don’t consider the PE in isolation

The PE ratio also presents problems when considered in isolation. A one-dimensional view might see the current forward PE as high, as it approaches its last peak which hit during the dotcom bubble. To overcome this, we can compare the inverse of the PE ratio (Earnings/Price) known as the Earnings Yield with the 10-year US Government Bond yield. This shows roughly what you can earn in stocks vs the risk-free rate.

As the following chart shows, in the late 90s you could earn about 6% on a risk-free 10-year bond vs about 3% on stocks, making stocks look relatively expensive. Today however, even though the earnings yield for stocks may be similar to the late 90s it’s now superior to the 10-year bond. I should note this chart also uses trailing earnings and therefore underestimates the earnings yield.

The PE is distracting

The last problem with focusing on the PE is that it distracts from more important metrics. Since Swell’s inception nearly six years ago, we have seen numerous occasions when market prognosticators have advocated selling because of a high market PE, yet time and again, they are proven wrong. If, like us, you prefer to invest in a concentrated portfolio of high-quality companies, market multiples are largely irrelevant.

We prefer to spend our time understanding the growth drivers of individual companies so we can estimate their true, intrinsic values rather than focus too much on the overall market.