P/E ratios are a cornerstone of fundamental stock valuation analysis, and are most commonly looked at for individual firms. The P/E ratio is (as the name suggests), a ratio of a stock price divided by the firm's yearly earnings per share. The implied logic here is that a mature firm returns all profits to shareholders via dividends. The P/E then becomes a measure of how many years it will take the investor to earn back their principal from the initial investment. For example, if you buy 1 share of ACME Co for $100, and ACME consistently makes profits of $10 per-share, per-year, then it follows that it would take the investor 10 years to earn back their original $100 investment.

P/E is calculated using the last reported actual earnings of the company. Let's look at another example - one where we expect future earnings to grow. Imagine TechCo was founded 5 years ago, and their earnings per year (per share) have been $0, $1, $1.50, $2, and $5. Let's also assume that TechCo's current share price is $100, just like ACME in the prior example. Because the most recent earnings-per-share for TechCo is $5, that means TechCo's P/E ratio is $100/$5 = 20. The message here is that, at current earnings, investors in TechCo will theoretically get their money back after 20 years. This is twice as high as ACME -- but why? If it takes twice as long for TechCo to make profits as it does for ACME, why is their stock valued at the same price? The answer is obviously the growth rate of TechCo's profits. TechCo is a new company, and has been growing profits very quickly over the last 5 years, and so investors expect that trend to continue. This is why high growth companies tend to have very high P/Es - the market has very high expectations for their future results (relative to current results).

The same analysis can be done to the entire stock market. By adding up the price of every share in the S&P500, and comparing that to the sum of all earnings-per-share generated by those companies, you can easily calculate the P/E ratio of the US stock market.

Below are both the total S&P500 aggregate value, and aggregate earnings.

Here is the same chart again, but with a logarithmic axis to more clearly illustrate that the data do track each other somewhat evenly.

The charts above show a clear relationship between price and earnings (particularly noticeable on the log chart). Just by eyeballing that chart you can see that both series have steadily risen over time, and that S&P500 price tends to stay (very roughly) 10x-20x larger than yearly earnings. By dividing price by earnings (the P/E ratio) we can see this relationship explicitly, below.

The chart above shows the standard calculation of the S&P500 PE ratio since 1950. Since this is a measurement of current price divided by most recent earnings, the calculation is subject to high volatility caused by peaks and troughs in the business cycle. For example, in mid-2008 at the nadir of the financial crisis S&P500 earnings across the board fell about 90% in about one year. Despite stock prices also going down significantly, this caused the market P/E at the time to spike over 120.

For that reason, rather than use the current P/E, when doing long-term analysis it is more useful to use the Cyclically Adjusted Price Earnings (CAPE) ratio. This is very similar to the regular P/E, but rather than using the most recent earnings data, the CAPE ratio looks at current price divided by the average earnings over the prior 10 years. The CAPE ratio is shown below, and largely follows the same trend as the current PE ratio with a lot of the volatility smoothed out.

The chart below shows the exact same CAPE ratio data series as the prior chart - only the y-axis has changed to baseline 0 at the average CAPE ratio value of 20.2, and now shows horizontal bands representing standard deviations from that average. This presentation is in line with our other valuation models.

As of November 30, 2023, the S&P500 P/E ratio is 52.9% (or 1.3 standard deviations) above its modern era average. By this valuation, the market is Overvalued (see our ratings guide for more information).

And finally, let's look at how this data corresponds to S&P500 performance.

This final chart shows two important ideas:

First, the main line shows the S&P500 since 1950, but color coded according to the standard deviation bands from our model. I.e., when the S&P500 was more than 1 standard deviation below its P/E average (such as in 1950, and again during the mid-70's to mid-80's) the chart is colored green, signifying undervaluation and a buying opportunity.

Take note of the dotted line in the chart above. This shows the price level of the S&P500 if it were continuously valued at the modern-era P/E (CAPE) average of 19.8. That is, the dotted line is simply 20x the CAPE ratio. That dotted line is moving up faster than ever before, as corporate earnings have just exploded over the last 30 years driven by the tech boom.

No single model fully encompasses market valuation. Below are some key items to keep in mind regarding the PE10:

The primary case against using historic PE as a valuation metric is the idea that PE ratios ought to be getting higher over time. Here is one cogent example of this argument. Changing market structures (e.g, heavier weight on high-growth tech stocks) have reasonably driven increased average CAPE ratios over time, as could/may have a multitude of other exogenous factors (e.g, recent Fed interest rate policies promoting low rates and high growth). As long as the economy/industry doesn't revert back to that of the 1960's, why should we expect market P/E ratios to?

There is no arguing that the CAPE ratio has risen over time, and particularly since ~2000 when tech/growth stocks have becoming increasingly dominant in the S&P500. We agree that it doesn't make sense to compare today's market to the 1800's, and so this criticism is primarily why we do not use data prior to 1950 in this model. And while the average CAPE ratio has continued to increase steadily since 1950 as well, it's reasonable to ask what the 'natural' rate of increase here should be.

Similar to the Buffett Indicator, the CAPE ratio does not take into account the current interest rate environment. Lower interest rates generally justify higher valuations because they reduce the cost of capital and increase the present value of future cash flows. Luckily, we examine and model the relationship between interest rates and stock prices in our Interest Rate Model.

The ten-year earnings average component in the CAPE ratio means it might not promptly capture the most recent profitability trends in rapidly evolving industries or fluctuating economic climates. This characteristic can limit its effectiveness as a real-time stock market valuation tool, particularly in industries that are heavily influenced by technological advancements and innovation.

For example, if AI creates a productivity explosion in the next few years, short and mid term firm profits will rise sharply, but will not be fully reflected into the CAPE ratio for 10 years. This will cause the CAPE ratio to suggest that the market is highly overvalued, when in fact it may not be. For investors seeking up-to-date insights, it's important to consider additional metrics and market indicators that react more quickly to present changes in profitability.