As of this writing, December 2, 2024, the S&P 500 has touched a new record high of 6,047. While the stock market often breaks its record high on the way up, back-to-back strong years have investors asking themselves, “Is the stock market too expensive?”

One of the most widely recognized financial valuation metrics is the price-to-earnings (P/E) ratio. It has been used for most of the stock market’s history to gauge if a company is overpriced, undervalued, or in line with investor expectations. The P/E ratio does not only apply to individual securities but can be aggregated across a sector or even the entire stock market.

Let’s start with what exactly a P/E ratio is. It is calculated by dividing a company’s share price by its earnings per share (EPS). Earnings per share is equal to a company’s net income minus preferred dividends then divided by all shares outstanding. So, if a company’s net income minus preferred dividends is $1 billion, and there are 50 million shares outstanding, then the company has an EPS of $20 ($1 billion profit / 50 million shares).

By itself, EPS can provide a measure of the company’s profitability, the higher the better. Sticking with the same hypothetical company, assume it is trading at $200 per share. Then the P/E of that company would be 10 ($200 share price / $20 earnings per share). It is simply comparing the company’s profitability versus what investors are currently paying to buy the stock.

Like all metrics, the P/E ratio is relative. To say a company has a high price-to-earnings and appears overvalued implies that its peers are trading at a lower valuation, or its P/E is higher than its historical average. Conversely, a relatively low P/E ratio would imply a discount or good value. Investors need to remember that while the P/E ratio is a helpful too, it is not without flaws.

This primarily stems from the fact that the stock market is a leading economic indicator, meaning share prices are already reflecting all available data and future expectations are factored into its share price. Whereas the denominator, earnings per share, is looking back at quarterly or annual profits. Many analysts attempt to avoid this by using a forward P/E ratio, that is it uses an estimated future earnings per share, but this means the denominator could be accurate or way off.

Even when an analyst uses the forward P/E approach, it can’t fully account for the instantaneous nature of stock prices. This dichotomy can be illustrated by a profitable company that came off a great quarter with a strong EPS report, but just released news that its new highly anticipated product has a defect, causing the share price to plummet on future expectations. The volatile nature of individual stock prices can affect the P/E ratio, making a company look expensive yesterday and cheap tomorrow.

Companies with high P/E ratios are often referred to as “Growth” stocks. The tech sector has performed this way for quite some time, causing investors to pay relatively high prices for their stock with hopes for future growth. Companies with low P/E ratios are considered “Value” stocks, having prices relatively low versus their earnings per share, as investors may not be considering explosive future growth prospects.

From a macro standpoint, P/E ratios can be telling about the overall stock market as we know that the historical data is accurate (it already happened and was recorded), and therefore gives a framework for which to compare current data. Arguably the most widely recognized bellwether for the overall stock market is the S&P 500 (the Dow Jones Industrial Average [DJIA or “Dow”] is older but only tracks 30 blue chip companies instead of 500). Here are the highest reported trailing 12 month P/E levels in the S&P 500 since 1926:

• August 1929 (The Great Depression): 20.46
• August 1933: 25.79
• May 1946 (Post WWII): 22.83
• December 1961 (following 1960 recession): 22.43
• February 1992 (following Gulf War recession): 25.49
• December 2001 (Dot-com bubble): 46.50
• June 2009 (Great Recession): 122.41
• December 2020 (COVID-19 Pandemic): 38.23

The current S&P 500 P/E ratio is 27.87 (as of 12/01/2024). The historical average for the index is 16.45 since 1926. If we look at more recent memory, since the turn of the millennium, it is 25.86. Historically speaking, the S&P 500’s price-to-earnings is high, but hardly near the levels seen around the Dot-com bubble or Great Recession. If investors are left wondering how the stock market could seem near appropriately valued while at an all-time high, they must remember the other side of the equation, earnings per share (EPS). If record stock prices are a symptom of record profits, the two can move on parallel paths.

So, is the stock market expensive? According to the P/E metric, it may not be there yet, but it is heading in that direction. The S&P 500 has recorded back-to-back years of 20%+ gains four times since 1950, barring a December collapse, 2024 will make it five times. For investors who appreciate historical trends, granted past performance does not indicate future results, take a look at the S&P 500 returns following such back-to-back years:

• 1954-1955 Rally… S&P 500 positive 2.62% in 1956
• 1995-1996… +31.01% in 1997
• 1996-1997… +26.67% in 1998
• 1997-1998… 19.53%. in 1999

A two year run seem like a long time, since the market pullback of 2022 when the Fed aggressively hiked interest rates to combat inflation, but bull markets tend to last longer than investors anticipate, roughly five and a half years on average.

When asked for a market prediction, many financial prognosticators like to reply, “They will fluctuate.” The S&P 500 is at a record high, and its P/E multiple is correspondingly high, but it is difficult to consider its current level a telltale sign. It would likely take a further rally in stock prices, or a collapse in profits, to move the ratio to a level that is clearly indictive of a bubble.

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