P/E ratios are often expressed in two ways, trailing and forward. Trailing P/E reflects how the current stock price measures up against earnings over the previous 12 months. For example, in early February 2023, the P/E ratio for the largest stock in the U.S. market, Apple Inc., was 25.61. That reflected its current share price in relation to earnings generated over the previous 12 months. A second way to assess valuation is by looking at P/E ratios reflecting anticipated (forward) earnings over the next 12 months. On that basis, the P/E ratio for Apple Inc. stock is slightly lower, at 24.69.1 P/E ratios are generally expected to be lower when based on forward earnings rather than on trailing earnings, as companies typically are expected to grow their income year-over-year.
Haworth notes that P/E ratio is just one measure of a stock’s performance. “We look at a variety of valuation assessments, including sales growth and book value growth, which is essentially a way of estimating the liquidation value of a company.” Other factors would include a company’s cash flow and a stock’s dividend yield.
When trying to assess which of two stocks offer the best investment opportunity based on their P/E ratios, it’s important to recognize that it’s not always an “apples-to-apples” comparison. “There can be variations in the expectations for different kinds of stocks,” says Haworth. “Determining fair value has a lot to do with the underlying growth rate of the industry in which the company competes.” Some stocks may be viewed with a longer lens, as investors demonstrate a willingness to bid up prices based not on current earnings, but on expectations of future profitability. “This tends to be the case, for example, with stocks that invest in new technology that may not have an immediate payoff but offer the potential of future strong earnings if they succeed,” says Haworth. “Other stocks may have lower P/E multiples, but those companies generate more steady earnings, so the payoff on the investment needs to happen in a more compressed timeframe.”
Factors affecting corporate earnings
While companies’ financial statements may seem straightforward, variables can be reflected in the earnings they report. It’s important to be able to understand the numbers that are most applicable to a stock’s valuation, and what might not be as pertinent.
“It is worth reading beyond the headline numbers,” says Haworth. “Unique, one-time events may affect earnings, either positively or negatively.” For example, if a company’s earnings declined due to a one-time major expense, that shouldn’t necessarily reflect poorly on its outlook. Similarly, if a company reports a strong boost to earnings, for example, because it sold off one of its units of business, that may not reliably indicate future strength.
How earnings are reflected in the broader stock market
Analysts often use earnings estimates to determine whether the broader stock market is fairly valued. For example, earnings of the S&P 500, an index of approximately 500 large company U.S. stocks, totaled $207.81 per share as of the third quarter of 2022, according to Factset Research Systems. The anticipated change in that number going forward can provide investors with a broad sense of the market’s valuation.
As they do with individual stocks, analysts can also place a P/E valuation on the broader market. As of January 31, 2023, the P/E ratio of the S&P 500 based on earnings in the prior 12 months was 19.17, while the P/E ratio based on projected earnings for the next 12 months is 18.4.2 Analysts may set different valuations on the market based on varied sets of projections.
When fundamentals are overshadowed
If earnings are assumed to be the most fundamental measure of a stock’s or market’s value, there are times when earnings are overshadowed. For example, in 2022, while corporate earnings were generally improving, stocks suffered a significant decline.
“In 2022, three primary factors shifted investor sentiment,” says Haworth. “High inflation, the Federal Reserve significantly raising interest rates and slower economic growth. Investors anticipated that all these factors would have a negative impact on the business environment, and ultimately, on corporate earnings.”
Markets experience such periods when non-market factors, some economic, some triggered by other events such as a geopolitical conflict or a health care crisis like the COVID-19 pandemic, overshadow current fundamentals related to earnings.
Preparing for the current environment
Haworth believes that earnings have returned as a primary focus for investors in 2023. “Now we’re waiting to see what impact the direction of the economy will have on consumer and business spending and how that affects corporate profit margins going forward.” He notes that in the early months of 2023, there appear to be many unanswered questions about the direction of the economy. How that is resolved will likely determine whether stocks can regain strength over the course of the year.
As you assess your investment options and how to best position your portfolio, it can be helpful to do so in the context of a financial plan. Talk with your U.S. Bank wealth specialist to review your current financial position and review whether any changes to your investment strategy may be warranted to better reflect your goals and time horizon.