Starting With the Basics: Price-to-Earnings Ratio

Before digging into what we think this stock market is worth, it’s important to recognize that valuations have not historically been good timing tools. There is essentially no correlation between valuations and where stocks will go over the subsequent year. However, P/Es have value as a basic valuation tool, especially as it pertains to predicting long-term returns. But it requires context. It’s easy to say that the S&P 500 at a forward P/E of over 21 (based on the consensus S&P 500 earnings per share estimate for the next 12 months) is high based on historical averages. But this approach importantly lacks context around where we are in the economic cycle, the levels and outlooks for inflation, interest rates, earnings, and corporate America’s capital intensity.

Perhaps the easiest one of these drivers to tackle is rates. A higher 10-year Treasury yield has historically correlated with lower P/Es, as shown in the “Higher Yields Tend to Drag Down Stock Valuations” chart. This intuitively reflects the time value of money — future earnings (or cash flows) are worth less today at higher interest rates than they would be at lower rates, and the required return threshold to justify equity risk is higher.