Author Topic: PE Ratio - please help me understand  (Read 3571 times)

Frugal Fran in Canada

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PE Ratio - please help me understand
« on: July 08, 2017, 09:06:12 PM »
I'm brand-new to investing (well, mostly - I've held a small amount in low-rise mutual fund RRSPs purchased from the bank that I never bothered to learn anything about).

I'm investing $45k.  Planning on following the Canadian Couch Potato model portfolio (somewhere between 'balanced' and 'assertive'), I got set up with TD Direct so that I could buy the e-series index funds.

I'm not trying to time the market here, but I do still think it's worth considering whether or not things are currently overvalued when sinking in a sizeable (for me, anyway) chunk of cash. I'm less concerned about regular contributions, because I recognize that the most important thing is that there are regular contributions.

So... after looking at the MMM post 'https://www.mrmoneymustache.com/2011/06/09/how-to-tell-when-the-stock-market-is-on-sale/, I started wondering if it is a good or bad time, but realize I don't understand the PE ratio properly

I've already sunk some of the cash into the TD Canadian Bond Index, but I'm wondering about the others, which have PE ratios* as follows:
TD Canadian Index-e :  17.30
TD US Index-e:  20.27
TD International Index-e: 16.93

* I'm using the Weighted Average PE Ratio pulled from ycharts

All of these (in particular the US Index) are higher than the stated magic PE ratio of 16.4.  But the MMM blog is referring to the SP500 Index, arrived at by calculating the weighted average of the P/E ratios of all the 500 companies in the S&P500 index (and the post is from 2011). 

So how do I figure this out for these other indices? Should I be calculating it manually? ycharts also provides a "Forecasted PE  Ratio". What's this? Am I overthinking this?

As you see, many questions!  Your knowledge is appreciated.

waltworks

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Re: PE Ratio - please help me understand
« Reply #1 on: July 08, 2017, 11:12:37 PM »
Yes, you are overthinking this/trying to market time. Put the money to work and forget about it.

-W

Telecaster

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Re: PE Ratio - please help me understand
« Reply #2 on: July 08, 2017, 11:57:02 PM »
Am I overthinking this?

Yes, you are.  P/E is predictive of long term rate of return.  That's it.

So in your case, the question is if remaining in cash is is predictive of higher rates of return than investing in stocks   (Answer:  No.)


Indexer

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Re: PE Ratio - please help me understand
« Reply #3 on: July 09, 2017, 08:58:15 AM »
-Everything that's been said.


This is going to sound harsh, but using PE ratios in a vacuum to try and outsmart the market is the perfect example of "having just enough knowledge to be dangerous."

PE ratios don't tell the whole story. A utility stock with a PE ratio of 15 is VERY different than a tech stock with a PE ratio of 15. The US having a higher PE ratio than emerging markets is also no surprise. Most investors are willing to pay a higher price for their earnings if those earning come from a company in a stable country that is friendly to corporations than they are to pay for earnings originating in an unstable country that could privatize corporations.

PE ratios can also stay elevated for long periods of time. The only times PE ratios have been under 16 for the SP500 since the early 90s was during the recession. If you avoided stocks when PE ratios were over 16 you would have missed the last bull market.

After reading Intelligent Investor I really dug into value investing. I didn't buy any individual stocks but I tracked several. The thing that stuck out was every time I found a company that was priced really good against its peers(ex. Chevron VS Exxon) after enough digging in financial statements I would see exactly why. If one company had a PE ratio of 12 VS another that was 17 there was always a damn good reason. Markets are very efficient at pricing securities against each other.

Markets as a whole can get a bit euphoric, but that is very hard to identify in the moment, and nearly impossible to time. Again, markets can be over or underpriced for years on end. If you wanted to identify periods where the whole market was mispriced PE ratios would be one of many, and probably the least important, metric you would look at.

Conclusion: over time stocks earn more than cash and its about impossible to time the stock market. If you need the money in the future(5yrs+) then stocks make more sense than cash.
« Last Edit: July 09, 2017, 08:59:46 AM by Indexer »

Itchyfeet

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Re: PE Ratio - please help me understand
« Reply #4 on: July 09, 2017, 11:19:10 AM »
Yes, I agree with all of the above. Just invest and forget.

I am also fairly new and ignorant to all this and in learning a little bit about PE I have concluded not to read too much into it.

For example the Australian share market is heavy on bank stocks and commodities which have a typically low PE, so the Aussie share market can't be compared to the US market which much more diverse.

The press says that the US market looks high compared to history but stocks like Facebook, Apple & Google are growing very fast amd the market is pricing on future earnings not historic.

For tech stocks looking at past 5 year average earnings is pretty meaningless. A fast growing tech stock with a PE of 25 could be a bargain.

If you are really concerned you could invest 50% today and 50% in 6 months time and then be right either way.



iceberg8

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Re: PE Ratio - please help me understand
« Reply #6 on: July 09, 2017, 12:48:06 PM »
Wouldn't it be better to invest it in, let's say 1/4's and let's say every quarter? Just to play with dollar cost average a little bit. In case the market falls too much after the first investment, you will buy the second one a lot cheaper, but if no fall occurs, a bit pricier. Maybe it is safer play, but not sure how much is 45K for you, if not much, then maybe buy in 1/2 or 1/1? Just an idea to the topic, maybe someone else will enlighten us better.
ignorance is bliss

bh2115

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Re: PE Ratio - please help me understand
« Reply #7 on: July 09, 2017, 05:37:46 PM »
Contrary to popular belief, I do believe that relative valuation questions should be asked when putting in a substantial amount of money. The most powerful variable affecting PE ratio are interest rates (most notably the 10 year bond). In the attachment you can see the CAPE (Cyclically Adjusted PE) ratio against the 10 year bond rate. The simple thinking is that if the 10 year is at 4%, then the inverse is a PE of 25 and typically investors pay a premium for the potential for growth.

So at current levels, US equities appear fairly valued (even at these elevated levels). The biggest question you have to ask yourself is do you believe that inflation will kick in forcing central banks to tighten (and ultimately cause an economic slowdown and a contraction in multiples). I believe that day will come in the next 5 years, but to the previous posters' points who knows when that occurs...

The summer/fall months (specifically August, September, and October) are usually some of the worst performing months so you could deploy a 16 week capital deployment where you dollar cost average over those 16 weeks. I think some of the best ETFs are still either in the tech sector or in Europe. Please look at MGK, VEA, VEU, etc.
 

LAGuy

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Re: PE Ratio - please help me understand
« Reply #8 on: July 09, 2017, 06:13:46 PM »
I found this recent article on Yahoo Finance to be a pretty summation of the argument on why current PE's don't seem to be particularly high right now.

https://finance.yahoo.com/news/stock-market-may-new-price-regime-20-years-112802224.html

A couple of my own observations beyond this article:

1) To get to the "fact" that the current market is richly priced, you need to include the period of the 1970's. If you go back even further, you'll see that the 70's was something of an anomaly as PE ratios generally were higher before the 70's (just eyeballing the charts it looks like the market probably hovered in the mid to high teens for average PE ratio with the occasional short lived swoon).

http://www.macrotrends.net/2577/sp-500-pe-ratio-price-to-earnings-chart

I think making an argument that the current market is expensive based on average PE ratios that included the 1970's is really flawed as the current economy looks absolutely nothing like that time with its high inflation and energy shortages. If anything the current economy looks to be nearly the exact opposite of those times.

2) The late 90's bubble was really huge! And it lasted a REALLY long time! If the current market is a bubble, then it's just in the first inning of this thing. And that's a ride you really can't afford to miss out on. Get scared when the financial press starts running the day trading barista articles.

3) To get the low, low PE ratios that the PE average and Shiller/CAPE scolds are always calling for, you basically are going to need a massive paradigm shifting event to occur. A truly Great Depression. A World War. An energy crisis. Run away inflation. Maybe we'll get that soon. Or, maybe we won't see such an event for 40 years. But high prices in and of themselves are NOT that event (not at these prices anyways: see 2000 bubble). So be VERY suspicious of anybody that quotes some ratio, chart, or other market metric and proceeds to say we're all doomed. It's some outside event that you don't yet foresee that will be your doom.

Retire-Canada

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Re: PE Ratio - please help me understand
« Reply #9 on: July 09, 2017, 08:23:06 PM »
I'm not trying to time the market here,

Yes you are. Stop it now. ;)

Pro tip easy way to tell someone is trying to time the market...they say something like "I am not trying to time the market, but.." and then they go on to talk about how and why they are trying to time the market.

thriftycanadian

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Re: PE Ratio - please help me understand
« Reply #10 on: July 09, 2017, 08:37:07 PM »
I suggest reading this - from JlCollins.
http://jlcollinsnh.com/2017/04/14/sell-sell-sell-sell/

Lots of factors impact which way the markets will go - no one knows for sure.  Jump in, invest often and rebalance once a year!

Frugal Fran in Canada

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Re: PE Ratio - please help me understand
« Reply #11 on: July 09, 2017, 08:51:12 PM »
Hi everyone,

Thanks for the thoughtful replies.... And little bit of kick in the arse ;)

I've been doing my best to educate myself since realizing I would soon have this chunk of cash and be able to get underway with investing (which yes, is a lot for me, but I should now also be able to add $6k/yr at least - I'm really just getting started). I know none of us are fortune-tellers and that it's important to get the funds invested. But tending (or trying) to be a smarty pants about most things in life, in general, I recognize that there is much that I don't understand about investing, and so I suppose that's been a bit of a pill to swallow when it comes to actually hitting that "buy" button.

Thanks in particular for the links and further explanations about PE. Having a better understanding of these crazy new investment terms, how the numbers are arrived at, and why people do or don't pay attention to them does a lot for improving my comfort level.

And yes, I'm going to go and jump the rest of the way in, in accordance with my original plan.

Cheers :)

Radagast

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Re: PE Ratio - please help me understand
« Reply #12 on: July 09, 2017, 09:39:43 PM »
I found this recent article on Yahoo Finance to be a pretty summation of the argument on why current PE's don't seem to be particularly high right now.

https://finance.yahoo.com/news/stock-market-may-new-price-regime-20-years-112802224.html

A couple of my own observations beyond this article:

1) To get to the "fact" that the current market is richly priced, you need to include the period of the 1970's. If you go back even further, you'll see that the 70's was something of an anomaly as PE ratios generally were higher before the 70's (just eyeballing the charts it looks like the market probably hovered in the mid to high teens for average PE ratio with the occasional short lived swoon).

http://www.macrotrends.net/2577/sp-500-pe-ratio-price-to-earnings-chart

I think making an argument that the current market is expensive based on average PE ratios that included the 1970's is really flawed as the current economy looks absolutely nothing like that time with its high inflation and energy shortages. If anything the current economy looks to be nearly the exact opposite of those times.

2) The late 90's bubble was really huge! And it lasted a REALLY long time! If the current market is a bubble, then it's just in the first inning of this thing. And that's a ride you really can't afford to miss out on. Get scared when the financial press starts running the day trading barista articles.

3) To get the low, low PE ratios that the PE average and Shiller/CAPE scolds are always calling for, you basically are going to need a massive paradigm shifting event to occur. A truly Great Depression. A World War. An energy crisis. Run away inflation. Maybe we'll get that soon. Or, maybe we won't see such an event for 40 years. But high prices in and of themselves are NOT that event (not at these prices anyways: see 2000 bubble). So be VERY suspicious of anybody that quotes some ratio, chart, or other market metric and proceeds to say we're all doomed. It's some outside event that you don't yet foresee that will be your doom.
This.

ChpBstrd

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Re: PE Ratio - please help me understand
« Reply #13 on: July 10, 2017, 12:19:33 PM »
Future earnings are what you are buying when you purchase an equity. So yes, PEs matter because they are a good clue about what those future earnings will be.

All this talk about disregarding earnings sounds a lot like 1999-2000, which I lived and invested through. We were told by the trendy experts that growth, specifically revenue growth, was all that mattered. It sounded like a fishy theory then, and it's double fishy now.

To factor in growth, look up the PEG ratio.

However it's true we must not attempt to evaluate equities by the same metrics used to analyze government bonds. The equity markets are more event-driven than math-driven. You can't just flip over a PE ratio of 25 and expect a 4% return from that equity. Maybe their product will become obsolete. Maybe interest rates will rise. Maybe sales will tank. Maybe mortgage defaults will slow construction which will slow lumber sales which will cause railroads to haul less.

Yes, at some valuation, even the staunchest stock market advocates would walk away. This isn't market timing, it's market pricing. There's always a good-yielding alternative to holding cash, even if it's writing put options to earn income until you get assigned on a dip.

PizzaSteve

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Re: PE Ratio - please help me understand
« Reply #14 on: July 12, 2017, 04:03:22 PM »
I found this recent article on Yahoo Finance to be a pretty summation of the argument on why current PE's don't seem to be particularly high right now.

https://finance.yahoo.com/news/stock-market-may-new-price-regime-20-years-112802224.html

A couple of my own observations beyond this article:

1) To get to the "fact" that the current market is richly priced, you need to include the period of the 1970's. If you go back even further, you'll see that the 70's was something of an anomaly as PE ratios generally were higher before the 70's (just eyeballing the charts it looks like the market probably hovered in the mid to high teens for average PE ratio with the occasional short lived swoon).

http://www.macrotrends.net/2577/sp-500-pe-ratio-price-to-earnings-chart

I think making an argument that the current market is expensive based on average PE ratios that included the 1970's is really flawed as the current economy looks absolutely nothing like that time with its high inflation and energy shortages. If anything the current economy looks to be nearly the exact opposite of those times.

2) The late 90's bubble was really huge! And it lasted a REALLY long time! If the current market is a bubble, then it's just in the first inning of this thing. And that's a ride you really can't afford to miss out on. Get scared when the financial press starts running the day trading barista articles.

3) To get the low, low PE ratios that the PE average and Shiller/CAPE scolds are always calling for, you basically are going to need a massive paradigm shifting event to occur. A truly Great Depression. A World War. An energy crisis. Run away inflation. Maybe we'll get that soon. Or, maybe we won't see such an event for 40 years. But high prices in and of themselves are NOT that event (not at these prices anyways: see 2000 bubble). So be VERY suspicious of anybody that quotes some ratio, chart, or other market metric and proceeds to say we're all doomed. It's some outside event that you don't yet foresee that will be your doom.
This.
Agreed.  That said, it is also hard to normalize earnings for accounting changes.  For example, post-Enron SOX legislation and more recently the introduction of IFRS (international financial reporting standards to replace GAAP in the US) made some companies change some fundamental earnings assumptions in their accounting.  Software companies, for example, were forced to be more conservative.  Nothing changed in terms of real cash flow and profit, but PEs rose.  This is one reason blunt valuation assumptions are not always accurate, not to mention structural changes like consolidation of competition or technology based automation that permanently reduce operating costs .
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Pizzasteve prefers to avoid excessive critical debates.  In the event of a post, no need to reply or quote if you disagree. I am posting information meant to stand on its own and hope to avoid back and forth debating.

Telecaster

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Re: PE Ratio - please help me understand
« Reply #15 on: July 13, 2017, 05:14:43 PM »
Future earnings are what you are buying when you purchase an equity. So yes, PEs matter because they are a good clue about what those future earnings will be.


Exactly.  Let's say you buy a car wash for $100, and the cash wash earns $10 a year.  That's a P/E of 10, right?  So you will make your money back in 10 years.

If you buy the exact same car wash for $200, or P/E of 20, you'll make your money back in 20 years.

A P/E of 29 isn't "bad."    But it does imply a lower rate of return than a P/E of 16. 










LAGuy

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Re: PE Ratio - please help me understand
« Reply #16 on: July 13, 2017, 08:03:25 PM »
Look at the 70's. Low P/E's. However, not exactly a great time to be in stocks. Sometimes something is cheap because it sucks. And sometimes something is expensive because it's awesome.

Itchyfeet

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Re: PE Ratio - please help me understand
« Reply #17 on: July 13, 2017, 08:29:44 PM »
Future earnings are what you are buying when you purchase an equity. So yes, PEs matter because they are a good clue about what those future earnings will be.


Exactly.  Let's say you buy a car wash for $100, and the cash wash earns $10 a year.  That's a P/E of 10, right?  So you will make your money back in 10 years.

If you buy the exact same car wash for $200, or P/E of 20, you'll make your money back in 20 years.

A P/E of 29 isn't "bad."    But it does imply a lower rate of return than a P/E of 16.

I think getting a pay back on an investment over 20 years is very bad.

However, if you knew that the profit of the car wash was going to double every year for the next 5 years, well then the investment starts to look very attractive ie
Year 0.  $10
Year 1.  $20
Year 3. $40
Year 4.  $80
Year 5. $160

Investing at 29x or whatever today when you are buying a stock with a very strong growth outlook could be a bargain.

ChpBstrd

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Re: PE Ratio - please help me understand
« Reply #18 on: July 14, 2017, 08:50:12 AM »
Future earnings are what you are buying when you purchase an equity. So yes, PEs matter because they are a good clue about what those future earnings will be.


Exactly.  Let's say you buy a car wash for $100, and the cash wash earns $10 a year.  That's a P/E of 10, right?  So you will make your money back in 10 years.

If you buy the exact same car wash for $200, or P/E of 20, you'll make your money back in 20 years.

A P/E of 29 isn't "bad."    But it does imply a lower rate of return than a P/E of 16.

I think getting a pay back on an investment over 20 years is very bad.

However, if you knew that the profit of the car wash was going to double every year for the next 5 years, well then the investment starts to look very attractive ie
Year 0.  $10
Year 1.  $20
Year 3. $40
Year 4.  $80
Year 5. $160

Investing at 29x or whatever today when you are buying a stock with a very strong growth outlook could be a bargain.

What would have to happen for the performance of all the companies in the S&P 500 to look something like this, at realistic but high levels of profit growth, of course? Yes, they'll grow, but what factors would have to be in place for that to happen at a fast enough pace to justify today's high prices?

-no recessions?
-falling interest rates?
-high inflation?
-peak employment?
-consumer debt rising 20% above already historic levels?
-corporate leverage increasing 10%
-continuation of free trade
-no major catastrophies, wars, etc.

There's always some constraint on growth and there always has been. The question of whether stocks are expensive can be answered by another question: Is there reason to believe profits will grow faster in the next 10y period than they have grown in typical 10y periods?

Retire-Canada

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Re: PE Ratio - please help me understand
« Reply #19 on: July 14, 2017, 09:32:28 AM »
The question of whether stocks are expensive can be answered by another question: Is there reason to believe profits will grow faster in the next 10y period than they have grown in typical 10y periods?

Sure. Automation, robotics, AI....lots of new tech that could revolutionize a ton of businesses.

PizzaSteve

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Re: PE Ratio - please help me understand
« Reply #20 on: July 14, 2017, 04:32:27 PM »
The question of whether stocks are expensive can be answered by another question: Is there reason to believe profits will grow faster in the next 10y period than they have grown in typical 10y periods?

Sure. Automation, robotics, AI....lots of new tech that could revolutionize a ton of businesses.
Good example is public transit, cabs, Uber model.  Lots of further room to use connected vehicles to create capacity, fuel economy efficiencies, reduce insurance cause through self driving cars.  This is likely within 10 years. 

- Farewell post on a positive note.  Cheers.
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Pizzasteve prefers to avoid excessive critical debates.  In the event of a post, no need to reply or quote if you disagree. I am posting information meant to stand on its own and hope to avoid back and forth debating.