There are metrics and ratios other than the PE ratio to estimate the intrinsic value of stocks but the PE ratio is by far the most well known.
Its relationship with inflation is less well known.
Usually when you encounter descriptions of the PE ratio, you’re presented with a run down of how to calculate it and how to use it to value the general market or individual listed companies.
Nothing wrong with that approach per se but not much is written about the impact of inflation when using the PE ratio in security analysis.
Possibly because we have been living through a long period of low inflation thanks to central bank intervention.
But there is a skill to arriving at the intrinsic value of a listed business or to getting a sense of general market prices and its current value using the PE ratio.
Its easier than you might think and it simply calls for remembering what has happened in the past and applying it to the present.
How inflation has influenced the PE ratio historically
Let’s take the S&P 500.
Put simply during periods of high inflation the PE ratio of the S&P 500 records lower multiples than it does in periods of low inflation and vice versa.
The PE ratio has an inverse correlation with inflation.
This is important to understand because if your money manager is using the PE ratio as part of a value approach to investing they could be miscalculating the value of stocks.
Here’s an example.
During the 1970’s in the United States inflation ran from 3% at the beginning of the decade up to 13% by April 1980.
During the same period PE multiples for the S&P 500 from high to low fluctuated between 18 and 8.
The US inflation rate from 2000 through to 2020 wavered between just over 5% to -2%.
In the same period the PE ratio for the S&P 500 went as high as 65 down to a low of 16.
The cyclically adjusted PE ratio (CAPE) for the the S&P 500 posted multiples between 7-10 during the 80’s and 14 to 44 from 2000 to 2020.
So you can see why it’s important to consider what the current rate of inflation is when considering what value of the S&P 500 is in today’s money using the PE ratio.
What is the value of the general market is right now?
Today market commentators are worried about rising inflation with a rise of 2.6% in March.
In 2020 inflation ran at approximately 1.3%.
These are still historically low numbers when compared with the raging inflation of the 1970’s and 80’s and the inflation range of between 5% and -2% over the last 20 years.
Listed businesses in the United States have also started to see inflation in their input costs; the costs associated with making things.
These costs will be passed onto consumers which will mean prices will rise pushing up the rate of inflation.
At least that’s the theory.
As for valuing listed business in today’s climate using the PE ratio, well the numbers don’t lie:
- 10 year US average inflation rate: 1.73%
- CAPE for the S&P 500: 37.56
- PE ratio for the S&P 500: 42.57
We’re still in a low inflationary environment despite worries of future growth in consumer prices and the S&P 500 is at an above average/high value for its earnings.
Spending a few extra moments to consider the inflationary environment when using the PE ratio will grant you a more accurate estimate of it’s intrinsic value.