united kingdomen
The power of earnings

The power of earnings

10-09-2018 | Monthly outlook

Investors should focus on the E and not just the P in the price/earnings ratio, says Robeco’s Jeroen Blokland.

  • Jeroen Blokland
    Jeroen
    Blokland
    Head of Multi Asset

Speed read

  • S&P 500 company earnings are growing faster than share prices
  • P/E ratios have fallen lately, making valuations more attractive
  • Macro factors favorable amid solid growth and low interest rates

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.”

Stay informed on our latest insights with monthly mail updates
Stay informed on our latest insights with monthly mail updates
Subscribe

Share prices on the S&P 500 and their underlying EPS values since 1989. Source: Bloomberg.

“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.”

Pushing valuations down

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%.

The price/earnings ratio of the S&P 500 Index since 2012. Source: Bloomberg

“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.”

Comparison with others

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.”

Focus on the E not the P

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.”

Subjects related to this article are:
Logo

Disclaimer

Please read this important information before proceeding further. It contains legal and regulatory notices relevant to the information contained on this website.

The information contained in the Website is NOT FOR RETAIL CLIENTS - The information contained in the Website is solely intended for professional investors, defined as investors which (1) qualify as professional clients within the meaning of the Markets in Financial Instruments Directive (MiFID), (2) have requested to be treated as professional clients within the meaning of the MiFID or (3) are authorized to receive such information under any other applicable laws. The value of the investments may fluctuate. Past performance is no guarantee of future results. Investors may not get back the amount originally invested. Neither Robeco Institutional Asset Management B.V. nor any of its affiliates guarantees the performance or the future returns of any investments. 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.

In the UK, Robeco Institutional Asset Management B.V. (“ROBECO”) only markets its funds to institutional clients and professional investors. Private investors seeking information about ROBECO should visit our corporate website www.robeco.com or contact their financial adviser. ROBECO will not be liable for any damages or losses suffered by private investors accessing these areas.

In the UK, ROBECO Funds has marketing approval for the funds listed on this website, all of which are UCITS funds. ROBECO is authorized by the AFM and subject to limited regulation by the Financial Conduct Authority. Details about the extent of our regulation by the Financial Conduct Authority are available from us on request.

Many of the protections provided by the United Kingdom regulatory framework may not apply to investments in ROBECO Funds, including access to the Financial Services Compensation Scheme and the Financial Ombudsman Service. No representation, warranty or undertaking is given as to the accuracy or completeness of the information on this website.

If you are not an institutional client or professional investor you should therefore not proceed. By proceeding please note that we will be treating you as a professional client for regulatory purposes and you agree to be bound by our terms and conditions.

If you do not accept these terms and conditions, as well as the terms of use of the website, please do not continue to use or access any pages on this website.

I Disagree