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What the Price-Earnings Ratio Tells Us About Stock Market Overvaluation

What the Price-Earnings Ratio Tells Us About Stock Market Overvaluation

There’s no denying that the stock market has an overvaluation problem. Look no further than the average price-earnings ratio of the S&P 500, a whopping 23.32—a 55% increase over its historical average of about 15. In other words, we can assume that the stock market is overvalued by 55%, numbers comparable to the late dot-com bubble from 1999 to 2001.  

The price-earnings ratio (P/E) is one of the most popular metrics that investors and analysts use to determine stock valuation, and how a particular stock measures up to industry benchmarks. The P/E ratio is a tool for determining whether a stock is over or undervalued, and it has reliably predicted stock price movements ahead of market expansions and downturns.

If you invest in stocks and other equities, it’s crucial that you know how to use the P/E ratio to detect vulnerabilities in the market as well as opportunities for growth. 

Calculating the P/E Ratio

The P/E ratio is the ratio of a company’s stock price to the company’s earnings per share (EPS). Therefore, you must first find a company’s EPS before you can plug it into the P/E ratio formula. To do this, refer to the firm’s balance sheet to gather the following data for a given period-end: 

  • Net income
  • The number of common shares outstanding
  • Total dividends paid on preferred stock

Now, take the company’s net income and subtract the total value of the preferred dividends. Then, divide that sum by the period-end common shares outstanding. The resulting figure is the firm’s EPS. The higher the company’s EPS, the more profitable the firm. 

You can use the company’s EPS to find its P/E ratio by dividing its share price by its EPS. For example, if Enterprise ABC is trading at $48 and its EPS for the most recent 12-month period is $6, then Enterprise ABC has a P/E ratio of 48/6 or 8. 

The P/E Ratio: A Closer Look

When P/E ratios are high, they signal that investors anticipate high earnings. Conversely, a low P/E represents investor pessimism regarding future earnings. 

If a stock has a low P/E ratio, it could reflect the company or fund’s genuine lack of growth potential. However, it could also signal a ripe opportunity to purchase an undervalued stock that will net a high return when the stock price eventually rises.

The S&P 500, a stock market index of the top 500 large-cap American companies, indicates that few publicly traded companies are currently undervalued. Rather, virtually all the top US companies listed in the S&P 500 are all have a P/E ratio of 22 or higher, including:

  • Apple (AAPL): 22.6
  • Facebook (FB): 32.3
  • Microsoft (MSFT): 28.7
  • Amazon (AMZN): 80.5
  • Alphabet (GOOG): 28.2

In the case of Apple, for example, a stockholder is investing roughly $22 for every dollar of earnings. Wharton Professor of Finance Jeremy Siegel finds that stocks with “low-twenties” P/E ratios tend to be the most sustainable despite being on the higher end of the historical average. This should be a cause for concern for those investing in stocks such as Facebook and Amazon.

It’s worth noting that the Federal Reserve’s longstanding quantitative easing (QE) program has caused P/E ratios to soar as stocks and other equities offer higher value than standard bond yields. In the event of a bond yield uptick, it rationally follows that the equities market will simmer as an increasing share of investors turn to bonds and treasury bills as safe-haven investments.

Does Your Portfolio Reflect Market Overvaluation?

The average stock price relative to earnings for the S&P 500 currently sits at an all-time high. Higher, even, than where it sat before the crash of the dot-com bubble and the late-2000s global financial crisis. If we look at valuation levels since the mid-1960s, the median P/E ratio currently sits 30 percent above the average in that time.

There’s something unsettling about this picture. If stocks are selling for significantly more than their earnings warrant, then they present a higher degree of risk than they do potential for growth. It would be prudent for investors to reallocate their holdings such that they aren’t overexposed to an equity market correction. Increasing one’s portfolio allocation to alternative assets would help mitigate the risk of a sudden stock market downturn.

Conclusion: Start Diversifying Today

The P/E ratio tells us that equity markets are currently overvalued. But, they’ve also been overvalued for many years. It stands to reason that, eventually, the bubble will burst and stock prices will reflect the earnings that they yield. 

It’s worth stating that there’s no way to predict the future. Only a year ago markets were down by the double digits and, since then, they’ve rebounded and then some. But it’s equally true that the stock market is heavily overvalued according to the most reliable metric available, and a correction could spark a full-scale meltdown. 

The US currently finds itself in the middle of a multi-quarter earnings recession. We may soon find the cleft between the market’s valuation and bottom-line performance recede, which would lead to a massive loss in investor confidence and possibly precipitate a market crash. 

Diversifying your portfolio with alternative assets such as precious metals, cryptocurrencies, and gold-backed IRAs can hedge against the risk of a sudden stock market decline. A slumping US manufacturing sector, an uncertain trade relationship with China, and stagnating GDP growth in 2020 may prove to be the tipping point for an overvalued and precarious stock market. 

Liam Hunt

Liam Hunt

Liam Hunt, M.A., is a financial writer and analyst covering global finance, US economy, commodities, stock trading, politics, digital marketing, and millennial investing.

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