The objective of today’s message is to share how I think about P/E ratios, and why I don’t find valuation-based arguments all that helpful.

Let’s start with a brief overview of the definitions of valuation and P/E ratio.

What is a P/E Ratio?

P/E ratios belong to the field of fundamental analysis and are used to measure valuation. The idea behind valuation is simple:

• If you buy a stock when it’s cheap or undervalued, then your returns should be higher.
• If you buy a stock when it’s expensive or overvalued, then your returns should be lower.

You can measure the value of an individual company or the entire stock market using the earnings of the S&P 500. For that, you need to understand how the P/E ratio works.

• P = price
• E = earnings

Thus, the P/E ratio is known as the price-to-earnings ratio. It ties the price of a stock to the earnings of the company whose value the share price reflects. Because I care more about using this as a gauge for the entire market, I’m going to use the S&P 500 as our example.

As of Thursday’s close, the S&P 500 carried a price of $4,080. that’s the P.

Calculating earnings is a little tricky. Some look at earnings over the past year, known as Trailing Twelve Months, or TTM. Others look at estimates for the next year reasoning the future matters more than the past. Because future earnings are nearly always higher than past earnings, a P/E ratio using TTM will be consistently higher than one that uses future earnings.

Current estimates for 2023 earnings are around $225 – that’s the E.

So, take the $4,080 price and divide it by the $225 earnings and you get a P/E ratio of 18.

That means the stock market is trading about 18 times this year’s earnings. In other words, stocks are trading at an 18 multiple.

You didn’t ask, but 2024 earnings estimates are approximately $250, so we’re trading at 16.5x 2024 earnings.

Now, absent context, those numbers mean nothing. Is 18x high or low? Here’s how it stacks up versus the range of the past ten years:

We entered 2013 with a P/E ratio of 13 and exited 2020 with a P/E ratio of 23. That marks the high and low water marks for the decade. The 10-year average is just over 17, and the 5-year average is just over 18.

Based on the past ten-year range we’re right around average. Moreover, at the October low, the P/E ratio descended to about 15.

Bears will argue the P/E ratio didn’t get low enough for the bear market to be over. To support their case, they might cite old bear markets that didn’t bottom until the P/E got down to 12 or 10 or whatever. Here’s an example:

Note how all the secular bear markets that preceded the 2000-2008 one didn’t trough until their P/E ratios got close to 10 or below.

How I Think About Valuation

I have a few quibbles with this:

First, valuation has run consistently higher over the past 40+ years than previously. I haven’t had a chance to buy the S&P 500 at a ten P/E ratio for my entire lifetime. There are myriad reasons for the higher valuation range we’ve seen but suffice it to say, the marketplace is entirely different than it was a century ago.

Second, valuations are extremely imprecise. They might be good for getting a general lay of the land, but to use them for timing your investments seems silly. I’ve heard the stock market was overpriced nearly every year since I started investing in 2006.

Third, every bear market is different and it borders on arrogance to think one has the ability to nail the exact P/E ratio that we will bottom at ahead of time. Barking that a 15 P/E ratio wasn’t low enough and that we must hit a 13 P/E ratio before bottoming seems as silly as arguing we won’t top at a 22 P/E ratio during a bull market because we must hit 24 first.

Fourth, close enough is good enough for me. If you want to own stocks for the long run but won’t buy when we’re 30% off the highs because you think we won’t bottom unless the market goes down another 10%, then I think you’re entirely missing the point. You risk missing out on the next double or triple in the stock market because you don’t want to suffer through what might be a temporary decline of 10%+. Sounds irrational.

Fifth, timing your purchases with certain valuation levels seems like you’re making things harder than they need to be. If you have a cash hoard you want to put to work when stocks go on sale, I suggest the “seed sower” idea laid out in our Bear Market Survival Guide. Instead of trying to time the bottom by buying all at once, buy incrementally when prices sag to certain thresholds, such as down 20%, down 25%, down 30%, and so on. This is similar to buying when the P/E ratio descends to certain levels. I just think its simpler.

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