Wednesday, July 25, 2012

Price/Earnings Ratios

A lot of stock price changes have to do with the rising and falling of P/E ratios. Or, in other words what people are willing to pay for earnings. When the P/E is 10, people are willing to pay $10 for each $1 of earnings.

If you look at the action of the TSX and S&P 500 what you see is changes in P/E. People are constantly changing their mind on what they are willing to pay for earnings based on what they think that the future holds. However, it is not only that. Investors seem to act like a herd or a mob when it comes to valuing stocks.

The P/E ratio changes much more rapidly than any company's earnings reporting. Analysts often change their minds about quarterly earnings estimates also, so this does not help.

I have talked about the long secular bear and bull markets we have. The secular bull markets push the P/E ratios for the market higher. The secular bear markets pull the P/E ratios for the market lower. It is easier to find some statistics for the S&P 500 than the TSX. One paper said the over P/E for the S&P500 in June 2000 was just above 29. Another site said that the 1982 bull market began with the S&P500 trading on 7x earnings and yielding 6.3% and it ended in the tech blow-off at 30x earnings and a 1% yield.

The average P/E for the S&P500 is around 14. The P/E currently is at 15.57. There is a lot of historical data that shows that for a switch from a secular bear market to a secular bull to happen the P/E ratio for the market has to go below 10.

According to TSX site, the TSX P/E ratio is at 14.53 and the dividend yield is 3.17% on July 24th, 2012. To get to a P/E of 10, prices have to decline or earnings have to increase or have a combination of this has to occur. What is obvious is that we are not there yet, so expect more volatility.

Of course the gyrations of stock markets, especially in the short term, have nothing to do with what a company is actually worth. As an investor, you need to keep an eye on what the companies you have invested in are actually doing. How well your company does will, in the very long term, determine the stock price.

This blog is meant for educational purposes only, and is not to provide investment advice. Before making any investment decision, you should always do your own research or consult an investment professional. See my website for stocks followed and investment notes. Follow me on twitter.

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