Price-to-Earnings Ratio Lends Insight into Buying and Selling Stock

By Chris L. Meacham, CPA

Ben Bernanke set the market into a craze when he announced that the Fed may stop its bond-buying program earlier this year. Most of the reaction was concentrated on the volatility in the bond market that was created by the announcement. However, despite the negative effects created by the announcement, the stock market has chugged along reaching all-time highs up until recently.

Many investors are now wondering if it’s time to heed the old adage and sell high. In order to make a decision, it is important to figure out whether we are truly at the market’s high point, or if there is even more growth in store.

One measurement that can be very helpful is the “Price-to-Earnings Ratio.” The Price-to-Earnings Ratio (i.e., “P/E ratio”) is a company’s stock price against its earnings per share. In most cases, the lower the ratio, the better, as it translates to more value per stock price. For example, if the price of a stock is $100 and you are receiving $5 per share, the P/E ratio is 20. However, if you are earning $10 per share on a $100 stock, the P/E ratio is 10. Therefore, the stock with the 10 P/E ratio versus the one with a 20 P/E ratio would be likely less expensive in terms of return.

By applying P/E ratios to the S&P 500, you can better assess where the stock market is heading.

UNDERSTANDING P/E RATIO ON THE S&P 500

In 2000, the stock market at its high before the crash, P/E Ratio of the S&P 500 was at 25.6x. At the time, stocks were being highly overvalued respective to the actual profits these companies were returning. At its height in October 2007, the P/E ratio was 15.2x before the stock market experienced its crash.

According to Robert Shiller, the historical average P/E ratio for the S&P 500 is 15.5x. On June 30, 2013, the P/E Ratio was 13.9x. Therefore, while we are at an all-time high for the S&P 500, the stock prices were not extremely overvalued per its P/E ratio.

Another statistic that lends some perspective on the stock market is the correlation between interest rates and weekly stock returns.

Since 1963, data has shown that when 10-year Treasury yields are below 5 percent and rising, there is a positive relationship between yield movements and stock prices. Therefore, as interest rates continue to increase, stock prices may continue to increase as well up until the 10-year yield exceed 5 percent. Currently, 10-year yields are at 2.8 percent so it appears that there may be some room left for growth in the stock market.

Though it is always smartest to “buy low, sell high”, we may not have seen the stock market’s highest point yet as it could continue its recent surge; and with much uncertainty still in the bond market and with commodities, stocks could still be the most viable investment option.

For more information on how to use the current stock market to your advantage, give us a call at (858) 676-1000 or visit us online at

www.cornerstonewm.com

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