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Stock analysis with P/E: Has the market already processed the crises?

Recession, war, inflation, a possible banking crisis – stock markets around the world are currently moving in an environment full of uncertainty and negative headlines. Even in less turbulent times, it was difficult to assess why prices behaved the way they did. It is almost impossible to predict how the prices of individual companies or even entire markets will develop. Anyone who could do that would have the world formula for unlimited wealth. But there are various indicators that investors can use to try to get at least an idea of ​​where the journey is going. The central question right now is whether the negative news is already included in the prices in various markets (whether it is “priced in” as it is called in stock market jargon) or whether false expectations are keeping share prices at a high level.

To answer this question, analysts look, among other things, at fundamental figures such as the price-earnings ratio (P/E). This puts the current price of a share in relation to earnings per share. Price-to-earnings ratios around 10 are considered low, while those over 30 are typically high. The faster a company grows, the higher the P/E ratio it is allowed to trade on the stock market.

“Bloomberg” columnist Nir Kaissar looked at which statements can be made on the basis of the P/E using various indices. He investigates the extent to which bad news is already priced into current stock prices. To do this, he looks at the P/E ratios expected for the current year (current prices divided by the expected company profits) and compares them with the historical P/E ratios of various indices. According to Kaissar, there have been a number of crises in the past, from the world wars to the 2008 financial crisis, where the bad news has come with a low P/E ratio. Accordingly, a P/E close to historical lows can be a good indicator that markets have already priced in the bad news.

Also read: The price-earnings ratio simply explained

For Emanuel Mönch, Professor of Financial and Monetary Economics at the Frankfurt School of Finance and Management, fundamental values ​​such as the P/E ratio are an important part of valuation practice, but conclusions about the under- or overvaluation of companies “must be treated with caution”. The P/E is one of many indicators that are also discussed in science, such as the dividend yield or the price-to-book ratio. How great the predictive power of these indicators is for an individual company or an index is assessed differently in the scientific literature. A low P/E, for example, can also indicate low growth and a critical company situation – the market is pricing in the expected profit, but does not expect it to be permanent.

The P/E ratios compiled by columnist Kaissar show strong differences between different regions and index types. The P/E values ​​of the US indices are currently significantly further from their historical lows than the values ​​of comparable international indices. The Russel 2000 Index, which tracks US small-cap companies, has a forward P/E of 23, while the MSCI EAFE Small Cap, which tracks similar companies in developed countries outside of North America, is at 13. In the case of the US index, the distance to the respective low point is a whopping 16 points, while the international MSCI index is only seven. US stocks are therefore valued significantly higher than those of other industrialized countries. These differences are particularly noteworthy given that problems such as high inflation rates and the previous pandemic affected both markets. Accordingly, it is reasonable to assume that bad news is priced into some stocks and markets more than others.

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According to Klaus Schlote, who is Head of Research at the brokerage house Solventis, one reason for this difference could also be the higher liquidity of the American market. Valuations are correspondingly lower in less liquid markets. The same applies to the US technology sector, where one sees significantly higher valuations – mainly because the companies are growing faster than typical values ​​from old industries. Accordingly, he considers the difference to be a typical US phenomenon.

But not only US companies show significant deviations in the Bloomberg data. For example, if you look at the two variants of the MSCI EAFE, which are geared towards either growth (growth) or value (value) stocks, the growth variant has a significantly higher P/E ratio of 21, while the value variant with a price-earnings ratio of nine is a full twelve points lower. What’s also interesting is that historical lows are only three points apart – meaning that value stocks are close to their bottoms while growth stocks are far away. Similar differences can also be found in the US indices.

Because growth and the associated future profits of the respective company are central to growth stocks, the cyclical ups and downs of the economy and the stock market do not play a central role for them, according to Emanuel Mönch from the Frankfurt School. Klaus Schlote sees the dependence of growth stocks on the interest rate environment as a possible explanation for the higher P/E ratios granted to stocks. According to him, the market is speculating on falling interest rates from the US Federal Reserve, which you can see “also in the valuations, which are going up again”.

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Schlote and Mönch emphasize that the P/E should only ever be used in conjunction with other indicators. The construction of the price-earnings ratio can also lead to misinterpretations. After all, falling prices when there is bad news briefly depress the P/E ratio, but if the expected profits are also corrected downwards afterwards, this effect is offset again. The low price-to-earnings ratio didn’t then signal an undervaluation, but it was rightly so low because the earnings quality was lousy. Anyone who only bought because of the price-earnings ratio is likely to be disappointed.

Also read: Rising interest rates and the banking crisis – should I park cash in money market funds?

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