As most of you can tell from my writing, I am a firm believer of passive investing. I believe in it as I do not have the skills nor the time to pick the correct stocks to beat the market. However, recently, I have been reading quite a bit of using the P/E (Price-to-earnings ratio) to gauge the state of an ETF.
For those of us who are not familiar, the P/E ratio is a metric that measures the market price of the stock against the company's earnings. A higher P/E ratio would mean that the stock price is relatively higher compared to the company's earning, vice versa. This would mean that the stock may be over-valued. Investors would also expect a company with a high PE ratio to have a higher growth rate.
Formula:
1. PE
(Price for one share)/(Earnings per share)
2. PEG
(PE ratio)/(Earnings growth rate)
Earnings growth rate = (EPS this year - EPS last year) / (EPS last year)
A recommendation by the legendary investor - Peter Lynch has said that you would want PEG to be less than 1. It would mean that the growth rate is higher compared to the PE ratio.
So, if we were to apply this to my most favourite index in the world. The S&P 500, we get the following graph:
From the picture above, we can see that the recent PEG ratio has been really really high if we used the Peter Lynch benchmark of 1.0 Hence, this might mean that the market might have really been over-valued.
With the recent prices, we can see that there has been a correction due to the bear market. But we shouldn't be diving straight in just because it is lower. It is not the time yet.
If we were to look at the PE ratio, we can see that the current PE ratio is still within the mean of the historical PE ratio. Hence, further reinforcing my opinion that we shouldn't be rushing into the market yet. Do note that I am not recommending anything, do your own research and studies for your own investment.
Limitations:
The P/E and PEG ratios use the market price and earnings. The market prices are easier to determine. But the earnings are harder to obtain as earnings are only updated on a quarterly basis and there is a need to determine the long-term and short-term earnings.
Thoughts and comments:
It was a fun exercise learning about the PE and PEG ratio. But if I were to consider the impact that this knowledge has on my investing approach, there would not be much changes. At most I will be more aware of whether the market is over or undervalued and would attempt investing more during the undervalued phase.
You can also look at these videos created by my friend Linus Lim about the same topic:
1. PEG Ratio: https://www.youtube.com/watch?v=jflc_hF__f0
2. PE Ratio: https://www.youtube.com/watch?v=9N6C4VCHaFI
With that,
Stay vested, stay frugal my friends.
Dionysius
Sources:
http://www.yardeni.com/pub/spearnrevalgrpeg.pdf
https://www.investopedia.com/terms/p/pegratio.asp
https://www.investopedia.com/investing/use-pe-ratio-and-peg-to-tell-stocks-future/
https://www.forbes.com/sites/greatspeculations/2018/11/19/pe-ratios-are-misleading-especially-right-now/#5a223a4a2281
https://www.sgmoneymatters.com/pe-ratio-investment/
https://www.dummies.com/personal-finance/investing/investing-in-etfs-for-dummies-cheat-sheet/
https://www.dummies.com/personal-finance/investing/the-all-important-pe-ratio-in-etf-investing/
https://www.advisorperspectives.com/dshort/updates/2020/04/01/is-the-stock-market-cheap
http://www.munknee.com/sp-500s-peg-ratio-suggests-overvaluation-coming-correction/
https://markets.businessinsider.com/news/stocks/stocks-most-expensive-price-earnings-growth-ratio-bank-america-valuation-2020-1-1028824543
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