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Stock Market Valuation Ratio Trends

February 16, 2018 • Posted in Fundamental Valuation

To determine whether the stock market is expensive or cheap, some experts use aggregate valuation ratios, either trailing or forward-looking, such as earnings-price ratio (E/P) and dividend yield. Operating under a belief that such ratios are mean-reverting, most imminently due to movement of stock prices, these experts expect high (low) future stock market returns when these ratios are high (low). Where are the ratios now? Using the most recent actual and forecasted earnings and dividend data from Standard & Poor’s, we find that:

The following chart shows variations in valuation ratios based on 12-month trailing earnings/dividends from the end of 1988 through the the third quarter of 2017. Solid lines show the behavior of the ratios, and dotted lines of the same color show their respective averages over the past 28+ years. Data are actuals. Operating E/P and as-reported (GAAP) E/P are now both below “normal.”

Operating E/P derives from corporate earnings sources expected by management to continue contributing to future earnings. As-reported E/P includes contributions to earnings from discontinued operations and anomalous (as judged by management) conditions. Operating earnings are arguably more forward-looking and optimistic. As-reported earnings are arguably more manipulation-free and realistic (sustainable).

Note that:

  • This is an in-sample view. An investor operating in real time would not know the average during the sample period.
  • Stock buybacks began augmenting/displacing dividends in the mid-1980s.

The next chart is a shorter-term view of 12-month trailing operating E/P for December 2007 through September 2017. The chart also shows the trajectory of operating E/P for the current Standard & Poor’s bottom-up operating earnings forecast through December 2019 (dashed line), assuming the S&P 500 Index persists near its recent level of 2731. If the Standard & Poor’s earnings forecast is accurate and the S&P 500 Index remains near this level, 12-month trailing operating E/P will rise back above its 28-year average of 5.56% as shown in the chart above.

The final chart presents a shorter-term view of 12-month trailing as-reported E/P for December 2007 through September 2017. The chart also shows the trajectory of as-reported E/P for the current Standard & Poor’s top-down as-reported earnings forecast through December 2019 (dashed line), assuming the S&P 500 Index persists near its recent level of 2731. If the Standard & Poor’s earnings forecast is accurate and the S&P 500 Index remains near this level, 12-month trailing as-reported E/P will rise back above its 28-year average of 4.82% shown in the top chart above.

In summary, current S&P 500 earnings forecasts indicate 12-month trailing earnings-price ratios rising from below to above generational “normal” over the next two years.

Cautions regarding this finding include:

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