By: Alexander Tecle
#Marketselloff #PEratios #Leverage #Debt #Notdoneyet
Many clients have asked me about whether the recent market sell-off has gone too far? The more relevant question is, have Price-Earnings (P/E) ratio’s contracted too far? To answer this question, the reader must first understand what a P/E ratio is and how it is interpreted. Definition per Investopedia, “the price-earnings ratio (P/E Ratio) is the ratio for valuing a company that measures its current share price relative to its per-share earnings. The price-earnings ratio is also sometimes known as the price multiple or the earnings multiple.” The various market indices can be tracked as an amalgamation of their components P/E’s and trade based on either a forward-looking or 12-month trailing P/E multiple. Whenever you hear an analyst make an opinion of value of a particular market-index, they are normally making a statement about the P/E of a particular market based on it’s forward or forecasted earnings expectations. The average forward-looking P/E of the S&P 500 Index is fairly valued at an average of about 16.7x forecasted earnings. The S&P 500 P/E Ratio Forward Estimate is at a current level of 16.43x earnings, down from 16.90x earnings last quarter and down from 18.67x earnings one year ago. This is a change of -2.80% from last quarter and -12.00% from one year ago.
Most analysts might state that since the sell-off, valuations of the companies within the S&P 500 Index have come down significantly from their all-time highs and there might be an opportunity to obtain below average values during this period of multiple contraction. However, there has been as significant amount of debt added to the capital structures of companies in the recent years during record low-levels of market interest rates. As of June 2018, and S&P Global survey reported “U.S. companies have reached a record $6.3 trillion in corporate debt and the riskier borrowers are more leveraged then they were in 2007.” Although, the companies within the S&P 500 have over $2 trillion of cash on their balance sheet to service this debt, one might make the argument that the increased use of leverage in the late-cycle might weigh more heavily on the value of P/E multiples moving forward. The use of leverage helps enhance return on equity and improve corporate profits during expansionary periods of forecasted earnings. Heck, even if corporations are using the proceeds from debt to finance share buyback programs, this would have a positive impact on P/E multiples. I am concerned about the 3rd quarter decline of business spending and investment that was reported on the 3rd quarter GDP 3.5% growth rate. However, during this earnings season, we cannot deny that both institutional and retail investors have been highly concerned about slowing growth for forward-looking guidance on revenue and earnings.
When considering whether the recent sell-off in the market has been overdone and P/E multiples are more attractive, I would caution investors to look deeper into the earnings reports and assess how increased debt levels will impact earnings if growth forecasts continue to deteriorate. Perhaps, one might consider the average P/E ratio of the S&P 500 Index, adjusted for reduced sales growth and profit growth with higher leverage use as the new bar to be fairly-valued. Then, consider how much further down we must sell-off to reach that bar. With that said, we urge our readers to redress their equity exposure and make sure that their portfolio equity/bond/hedged investment allocation is in line with their risk number. Know your risk number!
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