How much would you pay to receive $1.00 a year from me? Would you pay $2? Would you pay $200?
If you paid $2, you would be paying two times the annual revenue? If you paid $200, you would be paying a hundred times revenue. This is the same concept as the "price-earnings (PE) ratio." How much would you pay for a stock that earns $1 per share per year?
Would you pay more when you are feeling optimistic? Is this decision driven by both economic and emotional reasoning? Now, take a look at this graph:
If you paid $2, you would be paying two times the annual revenue? If you paid $200, you would be paying a hundred times revenue. This is the same concept as the "price-earnings (PE) ratio." How much would you pay for a stock that earns $1 per share per year?
Would you pay more when you are feeling optimistic? Is this decision driven by both economic and emotional reasoning? Now, take a look at this graph:
You can see that investors have historically been willing to pay a maximum of 20-25 times annual earnings per share (EPS), as evidenced by the red line. Also, during the internet bubble of the late 1990s and early 2000s, the PE ratio stayed well above that red line. For a brief period of time during the early days of the financial crisis, the PE ratio spiked but only because earnings suddenly plummeted. Of course, it didn't take long before the PE ratio caught up with the falling EPS.
Now, notice the current level of share prices being about 15 times the earnings per share (EPS). This means the stock market is inexpensive or under-priced. Normally, I'd be buying stocks at a time like this. However, this is a clear reflection of the three wet blankets, i.e., the election, the fiscal cliff, and the European financial crisis.
Remove those wet blankets, and watch the market soar! Going from a PE ratio of 15 to 22 times, the stock market could rise a whopping 46%.
Will somebody please get these wet blankets off my PE Ratio!
Will somebody please get these wet blankets off my PE Ratio!
