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Jason Whiting | January 9, 2013

Question: How do current P/E ratios compare to historic averages?

How do current P/E ratios in the market compare to historic averages?    

–Dave

I actually didn’t know the answer to this question and had to ask someone internally to look up the relevant numbers. See the charts below for the trailing P/E ratios** for both the S&P/TSX and the S&P 500, going back quite a few years. (Click on the image to see a larger view.)

 

The reason I didn’t have these numbers at my fingertips is that I don’t consider market levels an important part of my investment style.  I’m a bottom-up investor that looks for good businesses (with an associated big idea), run by competent people that I can purchase at attractive prices, or, simply put: business, management, valuation.

If I find an investment opportunity that meets these criteria, I make the investment, and if not, I go to cash. Whether the market is above or below its long-term averages doesn’t impact my opinion of whether Rocky Mountain Dealerships* is a good idea at 9x forward consensus earnings.

As well, all my valuation work is based on absolute valuations and not those relative to an index. Again, Rocky is not attractive because it trades at an x multiple point discount to the TSX but because 9x forward consensus earnings is an attractive level on its own (in addition to the other valuation methods I use).

That said, below is the long-term P/E ratio for the S&P500 on the Graham & Dodd method (10-year historical earnings as the denominator), which is probably the best way to view the market’s multiple as it normalizes for short-term factors and has the longest history.

It appears safe to say that equity markets today are above their long-term averages.

However, there are a number of mitigating circumstances that make this less of a concern than it first appears.

The first is that alternatives, especially bonds, are at even more expensive levels. While the market was very cheap in the late 1970s, interest rates were in the mid-teens so even cash earned a very competitive return.

Secondly, the U.S. economy, and most developed economies for that matter, have become more efficient, specifically capital efficient. So, when the U.S. was dominated by steel makers, railroads etc. in the early 1900s those types of businesses deserved a lower earnings multiple versus an extremely capital efficient and high return business like Google*.

Finally, to my point about finding individual values, the market as a whole has never been more expensive – similar to the situation in early 2000. If you owned an index fund you’d have been essentially flat over that 12 year-period. However, in 2000 you could have bought world class companies like McDonald’s*, Diageo*, United Technologies* or Nestle* for around 15x earnings and gotten cumulative returns of 275%, 458%, 270% and 190% respectively.

So, yes, the market is expensive, but a bottom-up investor should be able to do well over the long-run.

*The above companies were selected for illustrative purposes only and are not intended to convey specific investment advice.

**Price-earnings (P/E) ratio, the most common measure of how expensive a stock is, is equal to a stock’s market capitalization divided by its after-tax earnings over a 12-month period.

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