Price to Equity Ratio and Growth

Mahmut Karayel
08 Dec 2020

As COVID-19 spreads with full speed, the stock prices are doing extremely well. The average price to earnings ratio (PE) of S&P 500 companies is at a historical high level of 37.4. Such are the conditions set up with the zero-interest-rate policy of the US Federal Reserve and zero cost electronic trading that many brokerages offer.

Price to Equity Ratio

Price the earnings ratio (PE ratio) is exactly what it says: the price per share of a public company divided by earnings per share of that company. It is the same as Market Capitalization divided by Net Income. Everything being the same year after year, this would give you how many years of earnings you need to recover your purchase price. PE ratio (or the number of years to recover) may be too high if either you paid too much for the company or if you are not getting enough annual earnings from the company.

Right now, the average PE ratio of S&P 500 companies is more than 37. Historically speaking, 37 is a very high average PE ratio. When interpreted as years, it is a long time. In fact, there were only three times in the last 50 years when the ratio was as high as today:

  1. After the financial crisis (earnings were too low)
  2. After the shock caused by September 11 (earnings were too low)
  3. Right before the dot com bust (prices were too high)

“Everything Being Equal”

Why are investors willing to participate in such long run bets in today’s market? The prevailing mood in the stock market is that everything will not be equal. Things will be bigger and better in the future. There will be growth! Many also believe that historical comparisons do not apply, because “This time it is different”. In a sense, this is true. We are going through a period of record low interest rates. If you apply the same logic to a safe bank deposit, you will get your money back in hundreds of years! If you have a very good bank, $1000 deposit will get you $1 of earning after a year. That said, 37 years look pretty good. In addition, transaction costs which would discourage participants from jumping in are non-existent. So many jumped in.

Growth, the Great Equalizer

If low PE is good and High PE is bad, why not pick the lowest PE portfolio until you are diversified? Because, if you take the expected growth into account and calculate the expected net present value of your stock purchase, you might find that the higher PE company is a better investment.

You can subscribe to Equity Fundamentals Data from a Data & Insights site like ALTADATA or Zacks and compare the P/E ratios of different companies, while accounting for growth. Here is the question to ask:

"What is the net present value of all that I should expect to get from this investment?"

At a minimum, you need to know: [my answers for this analysis is in brackets]

  1. How long will the recent growth trend last? [5 years, it is difficult to guess beyond that]
  2. What will happen afterwards? [valuations will revert to long term PE ratio]
  3. What is the long-term PE ratio of the market? [Median is 18, Average is 19. I used 18]
  4. What discount rate should I use for future cash flows? [Long run Equity Risk Premium has been 5.5%. This is the premium investors expect over bank deposit interest. I used 6% discount rate]

Here are the results:

EPS Growth Rate -10% -6% 6% 12% 22% 30% 39%
Equivalent PE Ratio 8 10 18 24 37 50 70

Notice that the median PE of 18 corresponds to the case where the growth rate is equal to the discount rate. If I find a well-managed company PE ratio of 8 and positive EPS growth, I seriously consider it. When I am considering a company with PE of 70, I carefully consider data about their growth potential.

None of this should be taken as advice; we are simplifying and experimenting. No one predicted the pandemic, for example.

Speaking of simplifications, Peter Lynch, the legendary investor, came up with a much simpler rule of thumb to account for EPS growth. If you see two companies with the same PE ratio, pick the one that is growing faster. In other words, take the ratio of the PE and the Growth Rate, and pick the smaller one. This is the PEG ratio. The lower the PEG ratio the better.

EPS Growth Rate -10% -6% 6% 12% 22% 30% 39%
Equivalent PE Ratio 8 10 18 24 37 50 70
Peg Ratio #n/a #n/a 3 2 1.6 1.6 1.8

Second Order Effects

We did not consider second order effects. Should we expect the same PE ratio from different industries? Uncertainty in the growth rate, and the confidence in our assumptions made above (1-2-34) are determining factors in answering this question. Then there is the risk appetite of the investor: Is a 10% growth rate with +/- 5% uncertainty better or worse than 15% growth rate with +/-10% uncertainty?

Happy data search. Happy investing.

Suggested ALTADATA Data References

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