Last year I wrote about the high earnings multiples of U.S. stocks. One of the easiest measurements of a stock, or stock market, is the relationship of earning to prices. For example: if Company A earns $1 over one year and the price of the stock is $20, its price earnings ratio is 20 (take the earnings and divide it into the share price). If Company B had earnings of 80 cents and it too had a stock price of $20, its price earnings ratio would be 25 (20 divided by .8). Currently, the trailing price earnings ratio (past years’ earnings) for the S&P 500 is 24.91. In other words, if you buy the S&P 500, you are paying 24.91 times the earning of the average stock during the prior year. This is about a 4% return on your investment. The dividend payment from the earnings amounts to 1.93%. Based on this information we can surmise that the average stock is earning about 4% and paying out 1.93% in income. This measurement is important because now you can compare the risk of buying the S&P 500 to buying other investments. For example: the Dow Jones Corporate Bond Index, pays 3.785% interest with less risk.

If you can earn more money investing in corporate bonds, with a low level of risk, why would you take the higher risk associated with stocks? When we look at the forward price earnings ratio of the S&P 500, in other words looking at what the likely earnings are for the current year, we find the ratio drops to 16.92. Now we understand that the current earnings, on the same group of stocks, is expected to increase from about 80 cents to $1.18 during the year, for an increase in earnings of 48%. This in turn means that these stocks might return about 7% going forward, rather than 4%, on your investment. It’s this potential increase in earnings, with likely commensurate increases in dividends that are the basis for buying stocks. As earnings go up, the result can be higher stock prices.

During 2017, the price earnings ratio rose significantly in anticipation of a tax reduction in the U.S. The enactment of the tax reduction on corporations has resulted in much higher earnings estimates for the future. The current forward price earnings ratio is much more in line with historic norms.

Ed Mallon

March 27, 2018