Summary
- The price/earnings (PE) ratio is one of the most widely used measures of company valuation.
- Through a simulation, we show that if growth is expected to slow down, then PE ratios are likely to go down, possibly in a dramatic fashion.
- For example, if earnings are expected to grow only 2% per year, then an attractive PE ratio would be 7.95. This is much lower than the PE ratio of 12, which is generally seen as attractive.
- For a PE ratio of 12 to be attractive, the expected earnings growth has to be at least 10.18% per year.
The PE ratio
The price/earnings (PE) ratio is one of the most widely used measures of company valuation (). It is calculated by dividing a company's share price by its earnings per share. Essentially, the PE ratio reflects a company’s value, as seen by the stock market, divided by its net profits.
What is an attractive PE ratio?
From early 2009 to early 2019 the SPY exchange-traded fund (ETF) has gone up in value approximately 222.72%. The SPY is an index fund, which tracks the S&P 500 index (, ). It had a relatively low net expense ratio of 0.09% at the time of this writing. The SPY has also paid dividends during this period. In early 2019 the dividend was a little less than 2%.
If you bought US$ 10,000 in shares of a company, and had a return comparable to buying and holding the SPY in the 2009-2019 period above, the shares would be valued at approximately US$ 32,272 after 10 years. The spreadsheet section in the figure below shows a simulation where earnings are assumed to grow 2% per year over a period of 20 years. As you can see, the value of US$ 32,272 is reached at year 10. The EP percentages go up because they assume that the share prices remain constant; in reality those prices would go up, keeping the PE ratio somewhat constant. The first EP percentage is the reverse of the PE ratio.
At the top left you see the PE ratio associated with this return. It is a fairly low 7.95. This is much lower than the PE of 12, which is often seen as attractive by investors. That is, if you want to purchase shares of a company whose earnings are expected to grow only 2% per year, and obtain a return for the next 10 years that is comparable to the S&P 500 in the 2009-2019 period, then you should buy shares in a company with a PE ratio of 7.95.
The same simulation-based approach can be used to find out what growth rate would be needed for a PE ratio of 12 to be attractive. This is summarized in the spreadsheet section in the figure below. For a PE ratio of 12 to be attractive, the expected earnings growth has to be at least 10.18% per year.
The PEG ratio
Note that the PEG ratio () in the first spreadsheet section, also shown at the top left, is 3.97. The PEG ratio is the PE ratio divided by the expected annual earnings growth. This PEG ratio is much higher than 1, which is generally perceived as an attractive PEG ratio. And still, the return on the investment in 10 years will no doubt be attractive (the S&P 500 had a remarkable run in the 2009-2019 period), as long as the PE ratio is a low 7.95.
In the second spreadsheet section, the PEG ratio is 1.179, which is much closer to 1. This highlights one interesting property of the relationship between the PEG and the PE ratios - it is a nonlinear relationship. The closer the earnings growth gets to zero, the more warped it becomes, pushing the PEG ratio higher and away from 1 (assuming that the PE ratio is positive).
When growth slows down, the stock market may collapse, even without a recession
The above discussion highlights the fact that, if growth is expected to slow down, then PE ratios are also likely to go down. PE ratios may go down dramatically, leading to a severe stock market correction, even without a recession ().
In fact, as we can see from the discussion above, a severe correction may happen even without earnings going down! In other words, earnings may still keep growing, but at such a slow pace that the market is compelled to adjust PE ratios downward to match the lowered return expectations.
