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.”
The Robeco Capital Growth Funds have not been registered under the United States Investment Company Act of 1940, as amended, nor or the United States Securities Act of 1933, as amended. None of the shares may be offered or sold, directly or indirectly in the United States or to any U.S. Person (within the meaning of Regulation S promulgated under the Securities Act of 1933, as amended (the “Securities Act”)). Furthermore, Robeco Institutional Asset Management B.V. (Robeco) does not provide investment advisory services, or hold itself out as providing investment advisory services, in the United States or to any U.S. Person (within the meaning of Regulation S promulgated under the Securities Act).
This website is intended for use only by non-U.S. Persons outside of the United States (within the meaning of Regulation S promulgated under the Securities Act who are professional investors, or professional fiduciaries representing such non-U.S. Person investors. By clicking “I Agree” on our website disclaimer and accessing the information on this website, including any subdomain thereof, you are certifying and agreeing to the following: (i) you have read, understood and agree to this disclaimer, (ii) you have informed yourself of any applicable legal restrictions and represent that by accessing the information contained on this website, you are not in violation of, and will not be causing Robeco or any of its affiliated entities or issuers to violate, any applicable laws and, as a result, you are legally authorized to access such information on behalf of yourself and any underlying investment advisory client, (iii) you understand and acknowledge that certain information presented herein relates to securities that have not been registered under the Securities Act, and may be offered or sold only outside the United States and only to, or for the account or benefit of, non-U.S. Persons (within the meaning of Regulation S under the Securities Act), (iv) you are, or are a discretionary investment adviser representing, a non-U.S. Person (within the meaning of Regulation S under the Securities Act) located outside of the United States and (v) you are, or are a discretionary investment adviser representing, a professional non-retail investor. Access to this website has been limited so that it shall not constitute directed selling efforts (as defined in Regulation S under the Securities Act) in the United States and so that it shall not be deemed to constitute Robeco holding itself out generally to the public in the U.S. as an investment adviser. Nothing contained herein constitutes an offer to sell securities or solicitation of an offer to purchase any securities in any jurisdiction. We reserve the right to deny access to any visitor, including, but not limited to, those visitors with IP addresses residing in the United States.
This website has been carefully prepared by Robeco. The information contained in this publication is based upon sources of information believed to be reliable. Robeco is not answerable for the accuracy or completeness of the facts, opinions, expectations and results referred to therein. Whilst every care has been taken in the preparation of this website, we do not accept any responsibility for damage of any kind resulting from incorrect or incomplete information. This website is subject to change without notice. The value of the investments may fluctuate. Past performance is no guarantee of future results. If the currency in which the past performance is displayed differs from the currency of the country in which you reside, then you should be aware that due to exchange rate fluctuations the performance shown may increase or decrease if converted into your local currency. For investment professional use only. Not for use by the general public.