What the P-E Ratio Is Saying

P-E Ratio Graph

With the S&P 500 index of large US stocks having risen by close to 150% since its trough during the financial crisis, are US stocks now overvalued? One way to answer this question is by looking at the price-to-earnings ratio (or “P-E ratio”), which measures how high stock prices are relative to the profits that companies are generating. If the P-E ratio for the market as a whole is higher than its historical average, investors may be overvaluing stocks and the future returns from investing in the stock market may be below average.

The P-E ratio for the S&P 500 is currently about 19.5, above its historical average of around 15.5, suggesting that stocks are slightly overvalued. But one problem with using P-E ratios is that companies’ earnings can bounce around a lot, making historical comparisons difficult. In hindsight stocks were clearly overvalued in the late 1990’s, when euphoria about the prospects for technology companies pushed the P-E ratio for the S&P 500 above 30. But the market’s P-E ratio also surged in early 2009 as companies’ profits collapsed during the financial crisis, and that coincided with the start of the current bull market.

One way to get around this problem is to use the average of companies’ profits over a number of years. Robert Shiller, a professor at Yale University and recent recipient of the Nobel Prize in Economics, popularized a calculation that averages earnings over a 10-year period. According to his calculations, this 10-year P-E ratio is currently above 25, substantially higher than the long-term average of around 16.5. This metric has its critics as well: some argue that it puts too much weight on periods of abnormally low profits, such as the financial crisis. Proponents retort that historically it’s been one of the most accurate ways to predict future stock market returns.

So are US stocks currently overvalued? According to either of these measures of the P-E ratio, the answer is yes.

Topics: Blog Stock Market P-E Ratio Robert Shiller Valuation