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Much has been written on measuring equity market valuations – but precious little on developing effective strategies to capitalize on the imbalances.

Measuring valuation

“Overvalued” and “undervalued” are two of the most frequently used words in the investment industry. Turn to any business channel and chances are you will hear talk about an undervalued stock or an overvalued market, or vice versa.

In addition to stock markets, participants in commodities, real estate, and bond markets are all focused on determining valuation levels. The popularity stems from the understanding that an undervalued market implies a higher likelihood of positive future returns.

Price to earnings ratio (P/E)

If you are considering purchasing stock and, therefore, becoming part business owner, the cost of company earnings is a key piece of information to evaluate. P/E ratio is one way to determine whether you are paying a fair price for current earnings. A straightforward calculation, the P/E ratio is the stock price divided by trailing 12-month earnings. P/E is the most frequently referenced financial ratio when determining stock market valuation. The calculation for earnings can vary, however, by using forward earnings, operating earnings or reported earnings – all are used in the ratio denominator. (The P/E ratios referenced in this article are based on as-reported earnings).

Individual stock P/E ratios can vary widely by industry and expected earnings growth. This article will focus on P/E ratios for the S&P 500 index.

Figure 1 shows the historical P/E ratio of the S&P 500 based on trailing 12-month earnings over the last 50 years. ¹ In general, the P/E ratio peaks along with market highs. However, the absolute P/E levels vary greatly from the S&P 500 index peak-to-peak and trough-to-trough. Historical P/Es alone are not useful in creating successful buy/sell signals.

Figure 1

Figure 1: Created by author. S&P 500® Earnings Data Source; 2020 S&P Dow Jones Indices LLC. S&P 500® Historical Data. (^GSPC) (2019). Yahoo!Finance.

Higher P/E ratios over the last 25 years

In Figure 1 we can see that the average P/E ratio during the past 50 years was 19.8. However, the average P/E for the first 25 years was only 15.1; since 1994, average P/Es have increased to 20.4. P/E ratios have been considerably higher in the last two decades versus preceding decades, which raises the question: What is different about the most recent 25 years?

One thing noticeably different between the 25-year period ending 1994 versus the 25-year period ending 2019 were rates of inflation. On average, inflation (CPI) was much higher through 1994 at 6% versus only 2% in the most recent 25-year period.