So fair value for your company is $34 per share (that’s your $2 per share in earnings times the “fair” P/E of 17). I’m thrilled if your stock is selling for $10, because my forward returns will likely be outstanding. Let’s see what that looks like next.
Median P/E and Forward 10-Year Returns
Median P/E can help us predict what future 10-year annualized returns are likely to be for the S&P 500 Index. Will your future burgers be pricey or cheap? The price at which you initially buy matters.
Here is how you read the following chart. (Data is from 1926 through 2014.):
• Median P/E is broken down into quintiles. Ned Davis Research looked at every month-end median P/E and ranked the numbers, with the lowest 20% going into quintile 1, the next 20% into quintile 2, and so on, with the most expensive or highest P/Es going into quintile 5.
• They then looked at forward 10-year returns by taking each month-end P/E and calculating the subsequent 10-year annualized S&P return.
• They sorted those returns into quintiles and determined that returns were greatest when initial P/Es where low and worse when P/Es were high.
With a current median P/E for the S&P of 24, we find ourselves firmly in quintile 5.That tells us to expect low returns over the coming 10 years. Though it appears that most investors are expecting 10% from equities, history tells us that the market as a whole will have a hard time growing much faster than our country’s GDP does.
Note that 4.3% returns are the average of what happens when stocks are purchased in the top 20% of valuations. That forward return number goes down considerably if we are in the top 10% or top 5%, which is where we are today. The following chart, from Ed Easterling, shows what 20-year returns look like based on starting P/E ratios. Using average P/E ratios rather than the median, we are looking at an average annual return over 20 years of less than 3% from where we are today. Again, not what investors are expecting.
