A standard characteristic of the investment markets is the inverse relationship between price-to-earnings (P/E) ratios and the yield on bonds. In the early 1980s, for example, interest rates were high -- between 10 percent and 20 percent. During that period, the average price-earnings ratio for the S&P 500 Index was approximately 10, but as interest rates declined to 8 percent and below, the S&P 500 averaged higher than a 17.6 P/E ratio.
For a single company, earnings per share (EPS) is a measure of the value of each share of ownership in the company. If company earnings are growing, the EPS grows. When the company adds more stock and EPS remains the same, it is a clear indication that the capital raised by the issuance of more stock did not add to the company's earnings performance. Similarly, when the company's EPS increases during a time of low interest rates, one reason for the increase in earnings is lower costs of borrowing to finance company operations. Since it is such a good reflection of the company's financial performance, EPS has a primary influence on the price of the stock. The average EPS of the S&P 500 Index is considered a reflection of the financial performance of the nation's public companies and a gauge of the strength of the broad market for stocks.
Earnings per share is used to find out if a stock is overpriced or underpriced by applying the price-to-earnings (P/E) ratio. This is found by dividing the stock price by the EPS. A high P/E ratio relative to other companies in the same industrial sector indicates the stock may be overpriced. A low P/E indicates the stock may be under-valued. A stock becomes overpriced because investor demand for that stock exceeds supply of available shares in the open market, so the price rises. Rising prices in a stock means its expected return is high. Similarly, when the average P/E ratio of the S&P 500 Index rises, it can be inferred that investors expect the stock market to provide high investment returns.
Low interest rates spur economic growth by making it less expensive for companies to finance their operations. Lower financing costs generally produce good earnings growth. Good earnings growth, in turn, is reflected in the price of the stock and an increase in dividends paid to investors. Higher stock prices and higher dividends mean higher investment returns. Since 1980, the growth in the average P/E ratio for the S&P 500 Index has been nearly exactly inverse to the level of the 10-year U.S. Treasury interest rate. In other words, the lower the interest rate, the higher the P/E ratio.
Investing is the process of seeking out the best returns on money invested, given a certain risk tolerance. If an investor is faced with buying a 10-year Treasury bond that yields less than 3 percent annually, the potentially higher returns available in the stock market look attractive. As investors opt for potentially higher returns from stocks, the stock market rallies, and P/E ratios expand. As interest rates rise, expectations for substantial earnings growth diminish, and stock prices begin to decline. As stock prices decline, P/E ratios contract. Again, as bond rates rise, P/E ratios decline because investors leave the stock market for the relatively low-risk returns available in bonds.
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