Historically, PE ratios have varied widely for the broader market, and for individual stocks and sectors. For example, the trailing PE  ratio of the S&P 500 has ranged from 5.9 to 122, between 1927 and 2019.  Why do PE ratios fluctuate so much? In this article we summarize 5 main drivers influencing changes in PE ratios.

Expected Growth Rate

Changes in earnings expectations are the most direct drivers of PE multiples. When management reduces or eliminates future guidance, the stock will often react negatively. Similarly, PE ratios often react to analyst commentary on future earnings growth rates. Using standard models of equity valuation, higher earnings growth rate is associated with higher PE ratios.

Risk

Companies facing high uncertainty have a higher cost of capital. A higher cost of capital translates into a lower PE ratio.

Sentiment

Closely related to related to expected future growth rates and risk, is general sentiment. Positive sentiment can reflect optimism about growth prospects, and low financial risk. Negative sentiment can reflect poor growth prospects and high risk. However, general market sentiment can impact PE ratios in a sector without causing analysts to update their growth and risk models directly. For example, President Trump simply Tweeting about a particular company can be enough to cause multi billion dollar fluctuations in market cap.

Fund Flows

Fund flows are an often overlooked determinant of PE ratios. When a popular index includes a stock, or adjusts its weightings of an industry, it creates a steady bid under prices. The reverse is true when stocks are removed from indexes. Index inclusion arbitrage is a common investing strategy. Stock indexes are security selection systems that follow particular rules that are usually insensitive to valuation and fundamental growth of companies. Consequently, ETFs that follow indexes buy indiscriminately with inflows, rather than buying less when prices are high more when prices are low, and less when prices are high.  Sometimes fund flows also reflect industry sentiment, but other times they just reflect automated allocation models.

Some investors have noted that the market is effectively bifurcated between stocks that are popular in ETFs, and those that are not. Stocks that fit with index selection criteria are bid up to much higher prices regardless of fundamentals.

Macroeconomic Environment

The macroeconomic environment also has a major influence on PE ratios of individual stocks and across sectors. Most analysts believe that lower interest rates generally justify higher PE ratios. When fixed income offers a lower return, it makes sense to pay a higher amount for equity earnings. This is because the inverse of the PE ratio is the earnings yield- a lower earnings yield means a higher PE multiple. Other analysts have questioned whether this relationship is reliable over all time periods. However, all you need to do is observe the market activity around the dates of Fed Meetings to realize that interest rates have a major influence on stocks.

Interest rates interact with other factors as well. According to Aswath Damodaran:  The PE ratio is much more sensitive to changes in expected growth rates when interest rates are low than when they are high. The reason is simple. Growth produces cash flows in the future and the present value of these cash flows is much smaller at high interest rates. Consequently the effect of changes in the growth rate on the present value tend to be smaller.

Closely related, inflation is also a major factor in determining PE fluctuations over time. History shows that during inflationary periods, such as the 1970s, return on equity across the market fails to keep up with the inflation rate. Consequently, earnings multiply contract when inflation rises. PE ratios are based on multiples of nominal, not real earnings. A high nominal return on equity is low in real terms in an inflationary environment. Since PE ratios are based on multiples of nominal earnings they are justifiably lower when inflation is high in order to compensate. Lower PE ratios also reflect a higher cost of capital in an inflationary environment.

PE Ratios and Earnings Derivatives

Analyzing changes in PE ratios for individual stocks and sectors requires separate analysis from merely predicting future earnings growth. Earnings derivatives make it possible to trade earnings as a separate asset class. Click here to learn more.