P/E Ratio

By itself the P/E ratio has been a very poor indicator in predicting future stock market returns. The only exception is when P/E valuations reach extremes and future stock market returns are looked at for one to three years out.

On a P/E based ratio, small cap stocks are valued above the 95th percentile historically. Large caps stocks are only slightly above average historically. Too some that means small stock caps are overvalued, while large cap stocks still remain fairly valued or even undervalued when looking at projected growth rates.

Looking at the P/E ratio by itself however is very misleading. After all, large cap stocks were fairly valued in 2007 prior to the last financial meltdown.

The E in the P/E ratio is for earnings per share. One of the biggest reasons for the difference in the P/E ratio of small cap stocks compared to large cap stocks has been the record stock buybacks by large cap companies. By buying back stock the company is able to inflate earnings per share which decreases the P/E ratio. Additionally large companies have been able to take advantage of low interest rates to restructure and take on more debt which also decreases the P/E ratio. If you back out the effect of stock buybacks on EPS and take increased debt into consideration, large cap stocks don’t appear to be as attractively priced.

In addition profit margins are at record highs. Profit margins only remain at record highs under optimal circumstances during an improving economy with low inflation and low interest rates.

Record profit margins have always reverted to the mean. Eventually they are impacted by increased interest rates, higher borrowing costs or increased competition. Therefore one must ask themselves; what would happen if interest rates increase and stock buybacks decrease? What is the likelihood of that happening in the near future?

A fundamentally driven bull market should be based on earnings growth as opposed to multiple expansion. The fact that much of the increased market valuations are due to multiple expansion rather than revenue growth, should serve as a warning sign for investors.