Validity of the PE ratio as a valuation metric

[Chuck]

Cam and all,
In the post “My inner trader returns to the drawing board” there is an Ed Yardeni quote about whether the “fair-value” PE could be double 15.0. Let’s do a quick and dirty thought experiment.

Playing around with a simple spreadsheet, and thinking of a dividend discount model for stock prices, earnings 1.00, (assumes a payout ratio of 100% or efficient reinvestment of retained earnings so common stockholders get it eventually), a 3% equity risk premium and a 3.67% long Treasury yield for a total 6.67% discount rate (fast and loose here) gives a price of 15, and a PE ratio of 15/1 = 15.

With long Treasury yields at say 1.5% the discounted value of future earnings is now 22.2 and so is the fair value PE ratio.

Then add the trillions of stimulus and Powell put. Say that takes the ERP to 1.84%. Now the discount rate is 3.34% and the PV of future earnings is 30, so the PE is 30. Fair value.

I conclude that the PE is only useful as a valuation metric when the discount rate for future earnings is stable. Long term charts of the market PE are not valid.

S&P 4000 anyone?

[rxchen2]

Well, of course we have no idea whether Yardeni was talking casually to an interviewer when he made the comment. Was he thinking out loud with an off the cuff remark, or had he given the subject enough thought/analysis and somewhat deliberately stated ‘double [the usual 15]?’

SPX 4000 – why not? That’s about a +30% gain from here.

Why pay 30x earnings to own stock? I think it comes down to supply and demand. If PE ratios for individual stocks can rise to unimaginable levels, then why not PE ratios for sectors/ indices?

[Author]

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