The S&P 500 P/E ratio is one of the most famous metric in the world. It is widely used to determine whether the index S&P 500 is “expensive” or “cheap“.
In other words, you can use it to know when it is a good time to invest in the S&P 500.
But, how can I understand what’s the meaning of the value of the S&P 500 P/E? Let me start by defining the P/E ratio.
What is the P/E ratio?
The P/E ratio is the abbreviation of the price to earnings ratio. It is the result of dividing the price of the stock by the earnings per share.
The equation is as follows:
This ratio compares the market value of a company with its earnings. It tells you how many years the business needs to generate earnings that equal to its current market value.
Let’s take a look at one example.
We have company A, trading in Wall Street at 10$ per share.We know that in 2019 it had 1$ of earnings per share.
If we divide the share price (10$) by its earnings per share (1$) we obtain 10. This means that company A will take 10 years to generate the current value of the stock.
This is a generally a short period of time, so we can conclude the company is cheap from its current P/E.
How to use P/E ratio to invest in S&P 500 index
The P/E ratio helps you to perform the valuation of companies/indexes. It is a key part of the fundamental analysis you should do before you put money in any company.
It is difficult to set a rule that applies to all the scenarios. But typically a P/E ratio below 15 means the company is cheap, and a P/E above 25 means the company is expensive.
It is also important to compare the range of values the P/E of the company has had in the past. This gives us an idea of what might happen in the future.
For example if we take a look at the S&P 500, we can see that the majority of the time PE has been in the range between 15 and 25. This means that historical data supports that if S&P 500 P/E is above 25 it is likely to suffer a correction in the near future.
On the other hand, if S&P 500 P/E is below 15 we can expect the price to raise soon.
Understanding P/E ratio is very important to be able to use it properly. If P/E increases it can be due to the price raises, or due to the earnings reduce.
At the same time, if P/E ratio decreases, it can be due to the price going down or due to the earnings increasing.
Obviously you cannot just use the P/E ratio to determine whether you should invest or not in a company. You need to take into account more metrics like the earnings growth, long term debt to equity ratio and price to book value.
Having said that, the P/E ratio gives you a lot of information about a company or sector. If earnings per share are raising, it is very likely that the price will increase soon. Price is usually trailing earnings.
Now let’s take a look at the evolution of the value of the S&P 500 PE during the years.
Historical S&P 500 P/E ratio
On the chart above we can see the evolution of the S&P 500 P/E value since 1957. As I mentioned before, on these 63 years the S&P 500 P/E has spent most of the time between 15 and 25.
S&P 500 P/E is expected to be on the 15 to 25 range
Now I am going to present both the S&P 500 price and S&P 500 P/E ratio on the same graph, so we can analyse the correlation between both metrics.
On the picture above we can see that when P/E is very low S&P 500 price increases in the following years.
On 1974 P/E reached its lowest point on 7.5. What happened afterwards was wonderful for S&P 500 investors. S&P 500 price rose 50% in 14 months, just a little bit more than a year.
On the 1975-1987 period the S&P 500 experienced a huge growth. During those 12 years it rose at an 16.5% average annual return.
Something very similar happened after the financial crisis in 2009. The stock market crashed, and P/E ratio reached a low of 14. After that, we had a wonderful period of growth for the S&P 500.
S&P 500 had a 15% annual return from 2009 to 2020. This means a total return of 373%.
If you had invested 10.000 euros on 2009, you would have obtained 47.300 by the beginning of 2020.
By checking the S&P 500 P/E value you can know when it is a good moment to invest on S&P 500
I believe the P/E ratio is the most useful metric to analyse the stock market.
Last year was one of the best years of the S&P 500, since it grew 30%. Current S&P 500 P/E ratio is 24. Does it mean S&P 500 is currently cheap or expensive?
I will leave the question unanswered so you can reply to me on the comments section 🙂
S&P 500 historical average return
We have just seen S&P 500 can give you outstanding returns, such as 15% annual return in a period of 11 years.
I know what you are thinking…Maybe I just picked the periods where S&P 500 had a good performance. Maybe I avoided the periods where the stocks went down (also known as bear market).
Let’s check the history of the S&P 500, going all the way till the beginning of this index, to the year 1871. Now let’s check the historical average return for the S&P 500 from 1871 till today.
The S&P 500 has averaged a 9% annual return since 1871 till 2020
9% annual return for 150 years, can you believe it? Just by investing periodically in an S&P 500 index fund you can get a 9% annual return. This is known as Dollar Cost Averaging strategy, and it’s one of the best investment strategies that you can have.
When you invest in the S&P 500 index, it’s important to think in the long term. You should aim to get this 9% annual return by investing regularly, hence forgetting about short term movements.
In the short term there is volatility. Economic news have a huge impact on the financial markets. Stock prices can change a lot from one day to another.
Therefore, you should not expect to obtain returns in a day, a month or a year. You should expect to get your capital back in many years.
I would like to highlight that these calculations are not adjusted with the inflation. If we take into account the inflation, the S&P 500 would average a 7% annual return since 1871.
You can check the S&P 500 return in any period of time with this calculator.
How to invest in the S&P 500 index
Investing in S&P 500 is very easy noawadays. There are many mutual funds that track the behaviour of the S&P 500. These funds are called index funds. You also have ETFs, which are very similar to the index funds.
You can invest in index funds and ETFs through many brokers. I recommend you to use the broker DEGIRO to invest in the Vanguard S&P 500 ETF.
I have a portion of my portfolio invested in this Vanguard S&P 500 fund offered by DEGIRO, and I am very happy with its performance.
DEGIRO has the lowest fees for investing in the stock market. I have not found another broker with lower fees. But that’s not their only advantage, their platform is very intuitive and easy to use.
I am going to sum up the options you have to register on DEGIRO:
Depending on your circumstances, click on the link that suits you the most!
If you want to learn more about DEGIRO, take a look at my super guide about this wonderful broker.
More posts related to S&P 500 P/E ratio
If you want to learn more about investing in stocks, I recommend you to carry on reading below:
- Index funds, the best way to start investing
- April 2020 portfolio analysis
- Initial guide to invest in stocks
If you have any questions, please ask them on the comments section below. I promise I will answer them 🙂