The price to earnings ratio or P/E ratio, often referred to as “the multiple”, is a commonly used metric for determining a stock’s valuation. While there are many other important ratios such as price to sales, price to book value, etc., the P/E ratio is the valuation metric most frequently used by investors. While we can determine this ratio simply by taking the stock price and dividing it by the earnings per share (EPS), the more difficult part of the equation is – what should the multiple be and why does one stock trade at a multiple of 40, and another at only 15? Why does the stock market historically trade at an average multiple of 17 but sometimes trades in the mid-20s and other times in low double digits or even single digits? While there are many reasons for the variability in the P/E, one of the biggest variables is the general level of interest rates. Multiples tend to be higher during periods of low interest rates such as we’ve experienced over the past decade with lower multiples occurring during periods of high interest rates.

It’s important to understand that P/Es can be calculated two ways, one based on earnings over the previous 12 months, referred to as the “trailing P/E”, and one based on the expected earnings over the next 12 months, called the “forward P/E”. Generally speaking if a stock has a trailing P/E ratio higher than the forward P/E, investors are expecting the company to have positive earnings growth. On the contrary, if the forward P/E is higher than the trailing P/E, investors may be forecasting an earnings decline.

Typically, companies with strong earnings growth trade at a higher multiple than companies with slower earnings growth. This is because investors are willing to pay more for rapidly growing businesses, which intuitively makes sense. The following example might be helpful:

Company A
Stock price $20 Current EPS $1 Projected EPS $2.50
Trailing P/E 20x, Forward P/E 8x

Company B
Stock Price $20 Current EPS $1 Projected EPS $1.20
Trailing P/E 20x, Forward P/E 13.3x

Company A is growing much faster than company B. Because of this, to maintain a multiple of 20x, company A stock price would need to rise to $50 while company B’s share price would need to rise to just $24. As you can see a company’s earnings growth has a huge impact regarding what multiple investors think is appropriate for that stock. But earnings aren’t the only factor. The other variable in determining the P/E is the “discount rate”, which is especially effective when helping to determine the multiple across the broader stock market compared to one individual stock. This discount rate is meaningfully impacted by interest rates, as described above.

When projecting earnings and cash flows, analysts must discount future cash flows to a present value, using the discount rate, which is usually the fed funds rate set by the federal reserve, or the yield on short term treasuries, a proxy for “risk free” returns. The higher the discount rate, the less future cash flows are worth and vice versa. The best way to demonstrate this relationship is by example using inflation and your earned income. If the inflation rate is high, for example 8% as it is today, your future earnings will be worth less than if the inflation rate was only 2%. Put another way a year from now your $100,000 salary, at a 2% inflation rate, will be worth $98,000 in purchasing power versus only $92,000 at an 8% inflation rate.

The same logic applies to stocks. When the discount rate is high, investors are likely to pay less for a company’s future earnings because those earnings will be less valuable in the future. If investors aren’t willing to pay the same price for earnings because of the higher discount rate, the P/E ratio will decline or “compress”. This is what we are seeing today as interest rates have risen from multi-decade lows, although they are still below historical averages. Following the Financial Crisis, when the Federal Reserve cut short term rates to basically zero, the price investors were willing to pay for earnings, the P/E ratio, expanded. More specifically from 2010 through 2019 (pre-pandemic) S&P 500 earnings growth averaged around 10% annual growth but the index produced an average annual return of 13.4%. The differential between these figures was the expansion in the multiple. Growth expectations were high and discount rates were very low. Now that interest rates are rising, multiples are compressing to account for the higher discount rate.

Fortunately, even with earnings growth slowing this year relative to the past two years (when both companies and consumers benefited from large amounts of low cost liquidity from the Fed and trillions of dollars of government stimulus from Washington) growth is still projected to be positive. The combination of lower stocks prices and higher earnings has brought the multiple from the low to mid 20s down to the 17-18 range, much more in line with historical averages, which makes sense given that interest rates are also normalizing. Put another way, with earnings growing (denominator increasing) and price declining (numerator decreasing) the decline in the P/E ratio back to the historical average is occurring more quickly than if both price and earnings were declining simultaneously.

What about companies with minimal or even no earnings? Quite a few public companies might offer innovative and promising products or services and may be growing their revenue rapidly but have yet to produce any earnings. For these companies, investors must look at metrics other than P/E to evaluate them as potential investments and their future business prospects. In other words, investors are speculating as to when these companies might ultimately become profitable and to what degree. This situation was common in 2020 during the Covid shutdowns Examples include: Zoom, Teledoc, Twilio, Docusign, Peloton, Palintir and many others, some of which are down 75% or more from their highs as investors once again care about earnings. Many of these companies with no earnings relied on debt to grow and operate. With interest rates rising, the cost of servicing that debt is increasing, making their projected timeline for profitably less certain and harder to predict. In contrast, high quality companies with strong balance sheets, predictable earnings, attractive free cash flows and pricing power should be able to better withstand difficult economic and market conditions than the previously described companies, providing long term investors the opportunity to invest in world class companies at a discounted price relative to just a few months ago.

In summary investors are adapting to a new investing paradigm of higher interest rates, slower growth (relative to the liquidity fueled pandemic recovery period of late 2020 and 2021) and tighter monetary policy from the Federal Reserve. Because of these changes, volatility over the short term will likely remain elevated as investors determine what earnings multiple make sense with higher interest rates and a higher discount rate. The silver lining to that cloud of uncertainty is that changing market conditions often creates opportunities to buy quality companies below their intrinsic or enterprise value. During periods such as this, for investors who choose to own individual stocks, we believe that companies with strong earnings, attractive free cash flows and excellent balance sheets provide a solid foundation for those who can tolerate the short-term price fluctuations of equities.

Hopefully this information helps you better understand how analysts and investors value companies under different market conditions. Please feel free to call us at any time if you have questions about the markets or your portfolio. As always, thank you for your trust, your confidence and your business.

W. Edward Sutton
President and Chief Investment Officer

Matt Bertoncini, CFA
Portfolio Manager/Analyst

The Sutton Wealth Advisors Investment Committee
W. Edward Sutton
Zachary Sutton, CFP®, EA
Matt Bertoncini, CFA

The information contained herein (1) is intended solely for informational purposes; (2) is not warranted to be accurate, complete, or timely; and (3) does not constitute investment advice of any kind. Neither Sutton Wealth Advisors, Inc. nor Purshe Kaplan Sterling Investments is responsible for any damages or losses arising from any use of this information. Past performance is not a guarantee of future results.

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