CAPE Research Catalog - A Financial Planner's Resource

What Are Stock Market Valuation Metrics

Stock valuation metrics are ratios that tell us how much stocks costs. There are many, many different valuation metrics. The most well known valuation metric is the Price-to-Earnings, or P/E, ratio. A stock's or stock index's P/E ratio can be directly compared to that of another stock or index. If Stock A's P/E is higher than stock B's, this means investors are willing to pay more money for a \$1 of Company A's earnings than for a \$1 of Company B's earnings.

Why Stock Market Valuation Metrics Matter - a Primer

Simply put, valuations matter because a change to the P/E ratio is one of the 3 sources of return from stocks and stock markets.

My favorite exploration of this topic is Chapter 2 of John Bogle's book 'Common Sense on Mutual Funds'.

In case you don't have this book on your bookshelf, I offer an extremely abbreviated summary:

The formula that will surprisingly accurately calculate the annualized total return of a stock or basket of stocks over any given holding period is

TR% = DY% + EG% + ΔP/E%

DY% = the dividend yield at the time of original investment.

EG% = the annualized growth/decline of earnings over the holding period.

ΔP/E% = the annualized change in the P/E ratio for the stock or basket of stocks over the holding period.

DY% and EG% are fundamental returns and ΔP/E% is speculative return.

Changes to the P/E multiple can more than offset or highly enhance the contribution of dividends and earnings growth over the 10, 15 and 20 year holding periods that the individual investor cares about.

It stands to reason that if P/E changes are a direct contributor to returns then they matter ... quite a bit!!

Here is another, deeper explanation of the 3 componenets of stock returns.

Click here to view a really cool chart that shows for every 10 year period what each component contributed to S&P 500 returns

It is extremely important to fully grasp the components of stock returns in order to understanding the value of PE and Cyclically Adjusted PE (CAPE) ratios to investors!!