When it comes to investing in stocks, many financial advisors and analysts will warn that a stock, or a collection of stocks, is overbought or oversold. This can mean a lot of things to a lot of people, but it usually relates to an important relationship that is the starting point of all financial analysis: the price-to-earnings ratio.
The P/E ratio gives you a very simple relationship between two things: how much is a company earning and how much are you paying to invest in those earnings. The ratio is easy to calculate: you take the current price of a stock and divide it by the earnings per share of the last four quarters. For instance, Coca-Cola (KO) earned $1.42 per share in the 2014 fiscal year, and the stock is now trading at about $42.25. Dividing the latter from the former, we see that KO is currently trading at a P/E ratio of about 29.75.
Is that high or low? The answer depends on a number of things, and frustratingly, there is no perfect P/E ratio for any stock or sector. However, the market will usually price growth at a higher P/E ratio. In other words, the more a company is expected to grow its earnings, the higher the P/E ratio will be. This is why Facebook (FB) has a P/E ratio of 70 and ExxonMobil (XOM) has a P/E ratio of 12. The market believes Facebook will grow earnings much faster than XOM, and it prices the company’s stock accordingly.
Historical P/E Ratios
When it comes to the market as a whole, U.S. stocks tend to have a certain price for the earnings that American companies can expect. The S&P 500 has a P/E ratio of its own, which compares the price of the index to the total earnings of the 500 companies within the index. Interestingly, this number can be extremely volatile, as you can see from the chart on this website.
However, there is an average P/E ratio for the last 140 years (15.5), and a more-or-less normal range of P/E ratios throughout history (between 10 and 20), although more recently that range has gone up a bit and been more volatile. At the height of the global financial crisis in 2009, that ratio spiked at over 123, or over 6x its current level!
When the market began to normalize in 2010, that ratio fell down to around 16, and it has been steadily climbing as a result. Throughout the strong bull years of 2013 and 2014, the P/E ratio continued to creep up, ending last year at 19.37, and it’s stayed at about that level today.
What It Means for You
Many people will attempt to time the market by pointing out that the P/E ratio can predict a stock bubble, and when it gets too high, it’s time to sell. Some pundits have even urged investors to sell as the P/E ratio reaches 20, which is a clear sell signal, they say, and a sign to go into cash.
Here’s a typical example of this kind of reasoning, pointing to a number of charts and technical indicators urging people to go to cash. Here’s another one, focusing on the fact that the P/E ratio is historically expensive at 18, far above the historical norm.
The only problem with these two doomsayers is that they were writing during the strong bull market of the last two years. If you followed the advice of the first article, written in December 2013, you would have lost the 14% gains the S&P 500 has earned since then. The second article, being later, would’ve cost you only about 10% in gains.
Instead of trying to time the market, there are other strategies that can take into account the P/E ratio and what it means. Having a plan and sticking to it is one; diversifying across asset classes, so that you are not too heavily invested in just one index, is another.