S&P 500 P-E says investors are looking for improved earnings
— -- Q: What is a typical price-to-earnings ratio (P-E) for the Standard & Poor's 500 and how does the current level compare?
A: The price-to-earnings ratio, or P-E, is one of the most commonly used tools by investors to measure how cheap or expensive stocks are.
P-E ratios are frequently used to evaluate individual stocks. The simplest explanation of a P-E ratio is that it tells you how much investors are willing to pay for each $1 in earnings generated by a company. P-E ratios are just a division problem: Stock price divided by a company's earnings per share. You can read more here about how investors use P-E ratios.
And there are different ways to measure P-E ratios, which you can read about here.
There are also ways to get P-E ratios for exchange-traded funds (ETFs).
As you can see, the simple concept of the P-E ratio can be made more complicated the more ways you look at it. But for the sake of your question, let's keep this simple.
For this exercise, I'll suggest we take a look at the P-E of the S&P 500 stock index based on what companies are expected to earn in the third quarter plus the previous three quarters. You can get these data from Standard & Poor's here.
Adding up the quarter's earnings, we see that between the fourth quarter of 2008 and the third quarter of 2009, companies are expected to earn $38.38 a share on an operating basis, which excludes certain one-time charges. We then divide the S&P 500's value of 1,000 by 38.38 to arrive at a P-E of 26.
That's just part of the equation. Next, we need something to compare that to. The same spreadsheet will help. If you take an average of column G in the spreadsheet, you'll see that the S&P has, on average, had a P-E of 19 since 1988.
This tells you a few things. First, the stock market is clearly looking ahead for better things. Since the P-E of 26 is higher than average, investors expect earnings to improve dramatically in the future. If they're right, assuming stock prices stay constant, the P-E will fall toward its historical average.
It's also a warning that if earnings don't improve, some stocks may be overvalued. And if that is the case, you might expect stock prices to drop and bring the P-E back down closer to its historical average.
Matt Krantz is a financial markets reporter at USA TODAY and author of Investing Online for Dummies. He answers a different reader question every weekday in his Ask Matt column at money.usatoday.com. To submit a question, e-mail Matt at mkrantz@usatoday.com. Click here to see previous Ask Matt columns. Follow Matt on Twitter at: twitter.com/mattkrantz