Price-to-Earnings Ratio

What Is the P/E Ratio?

The Price-to-Earnings (P/E) ratio divides the current stock price by the earnings per share:

P/E = Stock Price / EPS

Or equivalently, for an index: P/E = Market Capitalisation / Total Net Income

A P/E of 20 means investors are paying $20 for every $1 of annual earnings — or equivalently, the stock would take 20 years to earn back its purchase price (if earnings stayed constant).

Trailing vs Forward P/E

• Trailing P/E (TTM): Uses the last 12 months of actual earnings. More conservative; based on known data.
• Forward P/E: Uses next 12 months' consensus earnings estimates. More forward-looking; embeds analyst optimism bias.

The S&P 500's long-run average P/E is approximately 16–17x on a trailing basis. Post-2010, the average has been closer to 20–22x, partly because low interest rates justify higher multiples.

The CAPE Ratio

The Cyclically Adjusted P/E (CAPE), developed by Robert Shiller, averages 10 years of inflation-adjusted earnings to smooth out business cycle fluctuations. The long-run average CAPE is ~17x; readings above 30x have historically preceded poor 10-year forward returns. The US market CAPE exceeded 35x in 2021.

P/E and Interest Rates: The Fed Model

A widely used framework relates equity P/E to bond yields:

• When bond yields are low, investors pay higher P/E multiples for equities (the alternative yield is terrible)
• When bond yields rise, P/E multiples tend to compress (why own equities at 25x earnings when bonds pay 5%?)

This explains the violent P/E compression in 2022: the S&P 500 forward P/E fell from ~21x to ~15x as 10-year yields rose from 1.5% to 4.3%.

P/E by Sector

Growth sectors (Technology, Consumer Discretionary) trade at premium P/Es because investors pay for high expected EPS growth. Value sectors (Energy, Financials, Utilities) trade at low P/Es because their growth is modest. The P/E spread between growth and value is itself a macro signal.