Valuations Soar As Markets Rally: S&P's Highest Forward P/E Ratio Since 2004

The markets no doubt are on a strong upswing, resulting in valuations reaching elevated levels. The S&P 500 is in unchartered territory, as it closed at a fresh record high of 2,351 last Friday.

^SPX data by YCharts

Is the rally sustainable? Are corporate earnings equally strong to support such elevated valuations? Unfortunately, the answer isn't very encouraging. To understand this, one may have to understand a concept called price-earnings multiple.

P/E Ratio — An Investment Tool

The price-earnings multiple,  or P/E ratio in short, is mathematically the ratio of current market value divided by its earnings per share. The earnings per share used in the calculation could be the trailing 12 months, or TTM, or the forward twelve months.

How do we interpret the P/E ratio? A P/E multiple of say x implies that an investor has to pay x dollars for each dollar of earnings. Apparently, lower the P/E multiple, less risky is the investment option.

Related Link: Analysts Share Their Low Forward P/E Picks

Interpreting P/E Ratio

However, we cannot take that to be a blanket deduction. These are few instances when a company can command a higher P/E multiple and is still investible.

• Assuming a company has superlative revenue and earnings growth potential in the future, then a higher P/E valuation is justified. In this case, investors are willing to pay a premium for the future earnings before it can materialize.
• Certainty concerning the earnings potential could be a factor one may have to consider. A company with more certainty concerning future earnings is justified in commanding higher P/E multiple than another with a risky future earnings stream.
• The P/E multiple also varies with industries and sectors. The perspective here goes like this. Mature industries, which are characterized by more stable earnings, usually have low P/E multiples compared to young companies, which have massive earnings potential.

A low P/E stock may be 1) an undervalued stock that few investors follow or 2) a stock with limited prospect for future growth. For comparison purpose, one could consider the P/E of a stock relative to the average P/E ratio of the sector in order to judge whether is it undervalued.

For example, Chesapeake Utilities Corporation CPK is trading at a TTM P/E multiple of 24.32, while the average P/E multiple for the sector gas utilities is 14.60. This suggests that Chesapeake is overvalued. That said, the higher relative valuation is justified if it possesses future earnings prowess.

S&P's P/E Multiple At 13-Year High

Coming back to the S&P 500 Index, based on last Thursday's close of 2,347 and forward 12-month earnings per share estimate of $133.49, the forward P/E ratio for the index stood at 17.6. Factset presented a perspective into how the current multiple fares against historical values and what is driving the valuation.

The P/E of 17.6 is above the four most recent historical averages. The five-year average is at 15.2, 10-year at 14.4, the 15-year at 15.2 and 20-year at 17.2. Factset noted that the week ended February 17 was the first time the forward P/E ratio has been equal to or above 17.6 since June 23, 2004, when the index was at 1144.06 and the forward 12-month EPS estimate was at $65.14.

Since December 31, 2016, when the forward 12-month P/E multiple was at 16.9, Factset noted that the price of S&P 500 Index has risen by 4.9 percent and the forward 12-month EPS estimate by 0.5 percent. Thus, according to Factset, the P part of the P/E multiple has contributed mainly to the increase in the P/E ratio since the start of the first quarter. If not for the record earnings per share forecast for the S&P 500 companies for the second quarter of 2017 through the fourth quarter of 2017, Factset noted that the P/E ratio could be even higher than the current 17.6.