When a stock appreciates in value, how much of that appreciation comes from earnings growth and how much comes from PE expansion? (Note: PE expansion occurs when buyers are willing to pay a higher price for the same amount of earnings. The price per share / earnings per share or “PE” ratio increases.)
Clearly, PE expansion was a major factor in the stock market gains that occurred between 1982 and 1999. Crestmont Research has an interesting chart on its web site that shows year end PEs for the S&P 500. The chart is arranged to show secular (long term) bull and bear markets.
Over the 17 year period from 1982 to 1999 (which Crestmont Research and others characterize as a bull market), the average PE for the S&P 500 rose from 7 to 42. At an annualized rate, the average PE increased 12.8%. This is a significant PE expansion for the market as a whole. For the 10-year period from 1989 to 1999, the average PE rose from 17 to 42, an annualized increase of 9.5%. And, for the 5-year period from 1994 to 1999, the average PE rose from 21 to 42, an annualized increase of 14.9%.
During these periods, any basket of stocks that generally had the characteristics of the S&P 500 would have increased significantly in value due to PE expansion alone. Earnings growth and overall market PE expansion together provided some impressive gains during the 1982-1999 period.
There is not much an individual investor can do about PE expansion or contraction. PE expansion and contraction are long term cyclical events that happen to the market as whole. Market PEs have been contracting for the last several years. The current PE for the S&P 500 is around 17. Declining high and low PEs since 1999 can be observed on the SSGs of many stocks.
What does this all mean for the average investors? First, PE expansion is something we can hope for but, like the weather, can’t do much about. Second, PE contraction seems more likely than PE expansion for the market over the next few years and possibly longer. Just look at the historical market PEs. Will the current market PE contraction stop at 17 or continue to 15, 12 or 7, and, if so, when will it stop? Third, the current market PE contraction makes achieving a 15% annualized return even more of a challenge.