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Price/earnings (PE) multiples are standard market metrics. They're ratios that tell us how much investors are paying for a company's earnings, or the total earnings of a market benchmark.
For example, a PE ratio of 15 means that, if a benchmark's earnings total $100 when the earnings of each stock in the benchmark are added together, investors paying a 15 multiple of earnings are paying $1,500 (15 x $100) to own one share of each of the companies in the benchmark.
Right now, PE multiples are way above their historical norms. That's got lots of analysts questioning whether stocks are overvalued and headed for a correction.
But what if PE ratios aren't what they used to be?
If they're different, how are they different? And based on where they are today, are they warning us or misleading us about the market?
These are important questions to ask. It's even more important to understand why it's time to question PE ratios and what they may be telling us about where the market's headed.
A Sign of the Past
Lots of Wall Street analysts are saying, "Stocks are overvalued and overpriced."
What they aren't saying is that the reason they're overvalued may be that they're using old valuation models based on measures that don't apply in an equity world that's changed.
In traditional terms, equities are expensive. They are overvalued based on the Dow's PE multiple of 20.97 on Wednesday (according to The Wall Street Journal) compared to its historical average of 15.45 (that's according to Bloomberg).
It's important to note that these numbers are determined by trailing 12-month earnings, meaning actual earnings and not 12-month forward earnings estimates.
On a PE basis then, the Dow Jones Industrials could be viewed as being 35.73% overpriced.
Figures released by Robert Shiller put the S&P 500's PE ratio on Jan. 26, 2017, at 25.78, while its historical 12-month median trailing PE is 14.65.
That means the S&P 500, based on PE valuations, is 89.62% above the level history says it gravitates towards.
But PE multiples aren't what they used to be. Sure, they're calculated the same way, but they don't have the same relevance they used to and therefore aren't always going to be accurate barometers of equity valuation.
Take a look at the trailing PE on the S&P 500 over the past five years:
- Jan. 1, 2012: 87
- Jan. 1, 2013: 03
- Jan. 1, 2014: 15
- Jan. 1, 2015: 02
- Jan. 1, 2016: 18 (estimated)
In other words, price/earnings multiples have been rising steadily.
What seems frightening is that investors aren't paying more for rapidly increasing earnings. They're paying more for incrementally growing earnings, if not flat earnings.
Take a look at the S&P 500's earnings over those same five years (courtesy of New York University's Stern School of Business):
- 2012: $102.47
- 2013: $107.45
- 2014: $113.01
- 2015: $106.32
- 2016: $108.86 (estimate…
About the Author
Shah Gilani is the Event Trading Specialist for Money Map Press. In Zenith Trading Circle Shah reveals the worst companies in the markets - right from his coveted Bankruptcy Almanac - and how readers can trade them over and over again for huge gains. He also writes our most talked-about publication, Wall Street Insights & Indictments, where he reveals how Wall Street's high-stakes game is really played.