Observations: Dow Price/Earnings Ratio Impact on Future Returns

Sunday, February 22, 2009

Dow Price/Earnings Ratio Impact on Future Returns - A Summary

This post shows that, in general, investors buying the Dow index at low p/e multiples have received significantly higher returns than investors buying at high p/e multiples.

Stock Market Price-Earnings Ratios Are Important

In a previous post, I looked at the history of stock market prices over the last 100 years in order to provide some historical perspective. Price is important. However, I would argue that value is even more important; that's the subject of this post. My objective is to provide the same kind of perspective on DJIA (Dow Jones Industrial Average) valuation that the "100 Years" post provides on price.

Whether you are buying stocks, bonds, mutual funds, houses, cars or bananas, valuation is important. By "valuation," I mean relative price, the price you pay relative to the value you get, or relative to some measure of worth. Without some way of measuring worth we can't determine whether we're getting a good price.

P/E Ratios & Subsequent 10-Year Stock Market Returns -- in Dollars

Growth of investment in Dow Jones Index by beginning price/earnings (p/e) ratio

Growth of $10,000 Stock Market Investment by Starting P/E

In the stock market, valuation is most often measured by using price / earnings ratios, that is the price of a company's stock divided by the earnings of that company. This ratio is also referred to as the earnings multiple. Other methods used to assess valuation include price / book value, price / cash flow, etc. The common thread is that price does not exist in a vacuum, it is best evaluated relative to something else; only then can you tell whether the price is expensive, about average, or cheap.

Above is a graph (click to expand) showing the dollar impact of investing at high earnings multiples rather than low earnings multiples. This should give you a feel for how important valuation (p/e) is. The graph shows the growth of three hypothetical groups of investors over 10 years:

The "highest p/e group" invested at the average return of the years with the highest 10% of historical P/E ratios. These are the most expensive valuations that we have experienced. That portfolio would have earned 2.5% per year and had an ending value of $12,800.
The "lowest p/e group" invested at the average return of the years with the lowest 10% of historical P/E ratios. These are the cheapest valuations that we have experienced. That portfolio would have earned 13.9% per year and had an ending value of $36,750.
The "mid-level p/e group" invested at moderate P/E ratios. That portfolio would have earned 8.9% per year and had an ending value of $23,450.

Note: For other interesting views of the relationship between valuation and returns, see Starting P/E vs 10-Year Stock Market Returns (a scatter diagram), Starting P/E vs 20-Year Stock Market Returns, and P/E vs. 10-Year Rollings Returns.

The source of the data for this graph is the table below. That table expands the analysis to cover all 10 of the hypothetical investment groups, and time periods from 5 to 20 years.

Table Summarizing Price/Earnings Ratios & Future Returns

P/E Dectile vs 5, 10 & 20-Year Returns

Note: the average NPE was about 15.

Impact of Price/Earnings Ratios on Future Returns

The table above summarizes the history of price to normalized earnings ratios since around 1900 -- over 100 years of stock market history. I have used DJIA (Dow Jones Industrial Average) data for this analysis; the results using earnings multiples from the S&P 500 would be comparable. This analysis is based upon year-end prices and normalized earnings from 1898 through 2008 (see note at end of post re nomalization). The table shows:

Dectiles: The 10 hypothetical investor groups. Dectiles are similar to percentiles, but with the data sorted into 10 groups instead of 100 groups. The first dectile, then, is equivalent to the first 10 percentiles -- it contains the 10% of the years with the lowest normalized price/earnings (NPE) ratios. The 10th dectile, on the other hand, contains the 10% of the years with the highest NPE ratios.
Normalized price-earnings ratio (NPE): This is the ratio of year-end price to year-end normalized earnings. The numbers shown are the maximum and average NPEs for the years in each "dectile."
Forward returns: The average annual return earned over the next 5, 10 and 20 years for the years in this dectile.

One striking feature of the results is the consistent increase in forward returns as you go from the higher NPE dectiles to the lower NPE dectiles. I think this data clearly demonstrates the relationship that I hypothesized in Major Bull and Bear Market Cycles Since 1900 -- namely, as a general rule, the higher the normalized price earnings ratio, the lower the subsequent returns. (Note: the discontinuity at the 6th dectile is primarily due to the fact that most of the years in the first half of the 1990s were in the 6th dectile. Therefore, their 5-year and 10-year periods ended during the most recent bull market, providing some very nice returns.)

The bottom line? Ignoring valuation may be hazardous to your financial health.

In the next post I use these results to develop some worst-case scenarios by applying historic earnings multiples to recent normalized earnings.

Note regarding Normalized Earnings calculation: The normalized earnings for any year have been calculated by averaging that year's earnings with the 5 previous and 5 subsequent years' earnings. For a more detailed discussion see About Normalized Earnings & P/E Ratios. Dow earnings prior to 1929 are estimates.

Dow P/E Ratio History since 1929 - Yearly Chart
Dow Dividend Yield and Price/Dividend Ratio History - Yearly Chart: another key valuation measure.
Components of 10-Year Stock Market Returns: The contribution of earnings growth and dividends vs changes in valuation.
The Extraordinary Impact of Price to Earnings Ratios -- on year-to-year returns.
Earnings & Dividends Contribution to Long-Term Returns: comparison of impact of earnings growth and dividends vs impact of p/e on 50-year returns.
Major Bull and Bear Markets Since 1900 P/E ratios at major tops and bottoms; subsequent returns.
For lists of other popular posts and an index of stock market posts, by subject area, see the sidebar to the left.

This article was featured in the Carnival of Investing Strategies: Number 5.
Last Updated 2/22/2012