Investors should focus on the E and not just the P in the price/earnings ratio, says Robeco’s Jeroen Blokland.
Concern had risen that markets that keep hitting new highs may ‘correct’ at some point if valuations become too stretched. Shares worldwide tumbled earlier this year before resuming the bull market that has now been in place for a decade.
Investors need not worry so long as the earnings component of the price/earnings ratio which underpins all stock market valuations remains strong, says Blokland, senior portfolio manager with Robeco Investment Solutions.
“There has been a lot of talk about equity valuations in the last couple months and even years, especially when it comes to US price/earnings (P/E) ratios,” he says. “And while US stock markets are definitely not cheap, at times it seems that investors give too much weight to the price component of the P/E ratio, when it is really the earnings component that is driving the market.”
“Share prices and earnings per share tend to move together, although the relative pace at which they move changes from time to time. For example, the earnings of S&P 500 companies have risen roughly 20% during the last 12 months and are expected to grow even faster in the coming 12 months. This means the earnings of S&P 500 companies are, at least for now, growing faster than their stock prices. And this is exactly the reason why worries about elevated valuations have dropped considerably.”
Blokland says another way of looking at it is to take P/E ratios and compare them with long-term averages, as shown in the chart below. Earlier this year, the P/E ratio for the S&P 500 peaked at 23.3, but since then it has fallen to 20.8, a total drop in valuation of 11%.
“As the S&P 500 Index has been hitting a series of new highs recently, the significant drop in valuation should be attributed to fast-growing earnings, and not to lower equity prices,” he says. “In addition, the current P/E ratio is ‘just’ 7% higher than the long-term average over the last 30 years. Hence, when earnings growth beats price appreciation, valuation becomes more attractive, even as new all-time highs are reached.”
This concept also holds up in regions outside the US, Blokland says. “In Europe, the importance of earnings is even more clearly demonstrated than in US stock markets,” he says. “Over the last two years, the earnings of companies included in the MSCI Europe Index have risen by an impressive 88%. Stock prices, however, have gone up by ‘just’ 17%. For comparison, US stocks are up 40%, or more than twice as much as their European counterparts, over the last two years.”
“The combination of very impressive earnings growth and the somewhat lackluster performance of European equities has resulted in a structural decline in valuation. Since September 2016, the P/E of the MSCI Europe has fallen from almost 29 to just 17 now, a decline of 40%. Moreover, Eurozone stocks are now 15% cheaper than their long-term average.”
‘Valuation alone is not a very useful measure for tactical asset allocation decisions’
“The European example also emphasizes that valuation alone is not a very useful measure for tactical asset allocation decisions. European equity markets have been hindered by a continuous stream of political risks in recent years. The structural increase in political risk often leads to investors requiring a higher risk premium, resulting in lower valuations. This, however, does not take away from the fact that the stellar rise in European earnings has been a major driver of European stock market valuation.”
Blokland says it’s a similar story in emerging markets: “These, too, have been battered by both political and economic events, and because of this, both earnings growth and stock market performance have lagged that of other regions.”
“Apart from that, the picture is comparable to that of the US and Europe. Earnings have outpaced stock prices, translating into lower valuations now than a couple of years ago. Emerging markets are roughly 5% cheaper than their long-term average, compared to a sizeable premium two years ago.”
Blokland says that subsequently it is important for investors to focus on the E as well as the P in the P/E ratio. “When judging traditional valuation measures, like the P/E ratio, investors tend to focus too much on the price component,” he says. “That is especially true when stock markets hit new all-time highs, like they are doing in the US at the moment, and investor fears of overpriced stock markets subsequently rise exponentially.”
“The power of earnings should not be underestimated. Presently, global growth is solid, interest rates remain historically low, and wage growth is tepid at best. Together, these circumstances lead to very rapid earnings growth now and in the foreseeable future. While valuation itself is rarely the sole trigger for major reversals, falling valuations should always be considered a positive for stock markets.”
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商号等： ロベコ・ジャパン株式会社 金融商品取引業者 関東財務局長（金商）第２７８０号
加入協会： 一般社団法人 日本投資顧問業協会