HOW MUCH YOU MAKE as a stock market investor depends on how fast earnings per share grow at the companies you own and on how much you collect in dividends. But it also depends on the price you pay. How can you gauge how expensive stocks are? Probably the most popular measure is the price-earnings ratio, which is a company’s stock price divided by its earnings per share. Suppose you have a $34 stock with earnings per share of $2 for the past 12 months. The stock would have a P/E of 17.
P/E ratios can be tricky to analyze. For starters, make sure you understand what earnings are being used. Some P/Es are calculated using the previous 12 months’ reported earnings. Based on that measure, the U.S. market’s average P/E multiple was 16.5 over the past 100 years and 19.2 over the past 50 years. At the end of 2018’s third quarter, it stood at 24.4, well above the 50-year average.
Some investors prefer instead to use expected operating earnings for the next 12 months. This has the benefit of looking to the future, which is what investors care about. It also ignores the onetime writedown of assets, which can distort reported earnings, and instead focuses on underlying corporate profitability.
Using expected operating earnings has its own problems, however. You are relying on analysts’ forecasts, which are notoriously rosy. Moreover, while writedowns may be onetime, they do reflect an admission of management error (yes, money was lost) and those onetime writedowns seem to occur all too often.
Whether you are looking at trailing or expected earnings, those numbers are captive to the business cycle. During economic booms, robust earnings can make the market’s P/E ratio appear more reasonable than it is—which could be the case right now. Conversely, during recessions, companies may lose money, driving up the market’s P/E ratio and scaring off investors, when in truth it may be a great time to buy. To address this issue, some investors have turned to cyclically adjusted P/E ratios or they look at other popular measures of the market’s value, such as dividend yields and price-to-book value.