The S&P 500 is currently trading at a P/E ratio of 20.28. The long-term historical average P/E ratio of the S&P 500 is 15.53. Based on this information, the stock market is due for a correction of about 23% to reach fair value. With the stock market historically overvalued, should investors purchase stocks at this time? This article seeks to answer that question.
Does Value Matter?
The P/E ratio of a stock tells you how much money you have to pay for one year's worth of earnings in a stock. A P/E ratio of 5 means you only have to pay 5 years worth of earnings, while a P/E ratio of 30 means you must pay 30 years worth of earnings.
Intuitively, the less you have to pay, the better off you will be. The historical record shows this as well. The image below shows 10 year total price returns for the S&P 500 at various starting P/E ratios.
As the image above indicates, valuation matters. All other things being equal, the less you pay for a valuable asset, the better off you are.
Calculating Return
A stock's total return can be calculated as follows:
As an example, assume you purchases a stock for a price of $100. The stock pays $3.00 a year in dividends and has $5.00 per year in EPS for a P/E ratio of 20. Over 10 years, the stock pays you dividends each year for a total of $30 in dividends (this was not a dividend growth stock, apparently). Additionally, EPS increase from $5.00 to $10.00 per share, while the P/E ratio falls from 20 to 15. In this case, your return would be:
