PE Ratio Math

As we mentioned in the textbook, when you are examining ratios, it is important to not only learn if a ratio has changed, but why it has changed. A recent article about the PE ratio highlights our discussion. Most people believe that an increasing PE is due to an increasing stock price, but as with any fraction, a change can also occur due to a change in the denominator. Currently, the PE ratio of the S&P 500 is about 19, above the 5-year and 10-year averages of about 16. As a result, many market analysts are predicting a declining stock market. However, even with a falling PE ratio, stock prices can still increase as long as earnings per share increase at a faster rate than stock prices. While we are not predicting the stock market, the article does note there are many periods in stock market history that earnings growth exceeded stock price growth, PE multiples declined, yet the bull market continued.