Maybe we're thinking of the P/E ratio all wrong 🤨
Most see it as a measure of value. Maybe we should think of it as a margin of error. 🧐
When it comes to the stock market, there’s no avoiding the matter of valuations. And when people talk about valuations, they’re often referring to the price-to-earnings (P/E) ratio.
The P/E ratio is calculated by taking the S&P 500’s current level and dividing it by the earnings of the index’s underlying companies. For that denominator, analysts often use the trailing 12 months’ earnings, the expected next 12 months’ earnings, or the average of the last 10 years’ earnings. If the P/E on the index is above some long-term average, then it’s considered expensive. If it’s below, then it’s considered cheap.
But just because prices appear expensive doesn’t mean they must fall, and just because they appear cheap doesn’t mean they must rise. In fact, history shows that valuations tell you almost nothing about where stocks are headed over the next year.
I’ve always wondered why prices don’t behave more — dare I say — rationally over the short term in the context of valuations.
One possible explanation I’ve been pondering: Maybe we’re thinking about P/E ratios all wrong.