Volatility continues to whipsaw equity prices this week. Here are some tips on how to value stocks, to determine if prices are cheap or expensive. Historically, the average S&P 500 price-to-earnings (P/E) ratio has been 15.78. Based on the assumption that S&P 500 companies will produce $160 in 2020 earnings, the index would sit at 18.90 P/E at the close today.
One of the main reasons why equity prices continue to be volatile, is that it is very hard (if not impossible) to predict the impact of the coronavirus on corporate earnings. With such a wide range of potential outcomes, the market continues to try and predict future corporate earnings expectations based on headline news. Before buying or selling equities, one should understand the value in your transaction. Individual companies may trade at elevated P/E multiples because of their growth potential. Some of these companies grow into their earnings and meet this potential, other high flyers do not grow earnings, and that is typically when the price comes back down to earth.
Indexes tend to be much more consistent with P/E multiple ranges compared to individual stocks. Whether it is a stock or an index, here is how to calculate the P/E. It is simple, take the value of the index or stock, and divide it by the annual earnings expectations. For example, the S&P 500 closed today at 3,023.94. One analyst has an estimate of $160 in earnings for the S&P 500 as a whole in 2020. Using those figures, 3,023.94 / $160 = 18.90 P/E. The problem with stocks as a whole in this current environment is that no one knows what the impact of the coronavirus will have on corporate earnings. It is clear there will be some impact, and the volatility shows that there is a wide range of outcomes that the market is trying to predict. As an example, if there is a 10% negative impact on corporate earnings for 2020, the earnings number becomes $144. 3,023.94 / $144 = 21.00 P/E. There are other variables that go into determining the value of stocks, one of which includes the current interest rate environment. In times of low interest rates, stocks tend to trade in excess of their historical P/E ratios. However, a P/E of 20+ on the S&P 500 typically means that prices are high. Starting in April, it should become much clearer where the market should be valued once companies start to report Q1 earnings and provide guidance for the rest of the year.
When investing on your own, make sure to determine your stock or index P/E, and compare it with historical averages, to see what type of deal you may be getting in your transaction.