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What’s the Right PE Ratio?

July 29, 2014 | About:
Bronte Capital

The Dividend Guy Blog

11 followers

The market is too high, it has to go down…

I bet you have heard this more than a few times recently. Some investment gurus came out of their tombs and are back with their favorite REM song: “This is the End of the World as we Know it”. They had to hide for a few years after telling the world that 2008 marked the death of capitalism. Six year after the biggest financial crisis, it seems it was just like a bad dream and everything is back on track. But some people will tell you it’s impossible for the market to go up forever. They are right, there will be corrections, but it doesn’t mean the system will collapse this time.

Are We Really Paying Too Much for Stocks?

This is the right question you should ask yourself; are you paying too much for your next trade? I recently increased my position in Johnson & Johnson (JNJ) even if the current P/E ratio was over 19.

Truth is if I had waited a few weeks, I could have bought it a few dollars cheaper (the stock lost 5% in 5 days after posting great financial results). But that’s easy to say when you are playing Monday morning quarterback on your trades.

The real truth is Johnson & Johnson is a great company. The dividend will continue to rise in the upcoming years and the stock will continue to show growth. New drugs will be marketed and profits will continue to grow. This is why there isn’t a perfect time to buy JNJ, but there is a perfect trade to make: buying the darn stock.

I don’t mind the exact timing of my trade for that reason: I focus on buying a company that will grow in the future. The price may be slightly high, but I don’t mind because it will continue to rise. Waiting for the perfect dip never served me. If you have a technique for that, please let me know.

How About the Market Average P/E Ratio?

Now back to our gurus saying the market will crash because it is overvalued. I like when I read such things as I always wonder where they get the numbers to back their prophecies (if they back it up with anything at all!).

The following chart shows you the average P/E ratio of the S&P500 according to two important economic metrics: the strength of USD and the strength of inflation.

Average P/E Ratio

Low Inflation High Inflation
Weak USD 15.2 13.6
Strong USD 16.4 13.9

As you can see, the moment where stocks are at their peak in terms of valuation is when there is a strong dollar and a low inflation. Does that ring a bell? The USD is getting stronger as its economic environment improves. Inflation is still very low and under control. Therefore, the historical average of the S&P 500 PE Ratio should be around 16.4. We currently show a P/E ratio of 15.7. What does this tell me? There is still room for the market to grow!

What I like even more is the fact that the market has been up this year not because we have changed PE multiples, but because companies make more profit now that they were making a year ago.

This is exactly what we are looking for: companies increasing their sales and increasing their profits.

This is why I’m buying more JNJ and this is why I’m 100% invested; because I believe the company I own in my portfolio will continue to generate profits.

When you look at the overall P/E ratio valuation, most bubbles burst when the S&P 500 reaches high levels of 20 to 22. We are definitely far away from that. And if it ever goes to this level, I’ll be the first to tell you ;-). In the meantime, I’ll keep buying… and buying… and buying…


Rating: 2.8/5 (4 votes)

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Comments

pravchaw
Pravchaw premium member - 2 months ago

Where did you get the table from?

arurao7
Arurao7 - 2 months ago

same question. where did u get the table?

Also, look at Arnold (one of the gurus on gurufocus) has a great article on his website "century management" where he evaluates the inflationary periods of 1970s. The numbers you have are averaged over some period of time and don't reflect the peaks and troughs. It is easy to say I don't care of peaks and troughs, but is not easy to see your Stock P/E go from 20 to 10.

snowballbuilder
Snowballbuilder - 2 months ago

Uhm ...

When you say that the stock market is fully valued but not in bubble ok.. . I can agree.. But at least is fully valued .

When you say "there is still room for the market to growth " uhm ... Maybe ... But there is also a lot of room to went down .

When you say "this is why i m 100% invested " and " keep buying buying " .... You lost me .

I think its time be cautious and built up some cash .

I dont see any bargain around ....no big fat pitch around... I think is time to be patient and a bit. fearfull , let the value of our holding compound and build up some cash .

Just some thoughts

Ps : a curiosity: when have you started investing ? Before or after the 2008 - 2009 big crash ?

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