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Data: FactSet; Chart: Axios Visuals

A widely followed valuation metric suggests stocks have been getting cheaper over the past year, even as prices have surged to new highs.

Why it matters: When stocks rise and company market caps balloon, it’s tempting to think that the shares must eventually fall in order to get to more reasonable levels.

  • This doesn’t have to be the case when earnings prospects are improving.

The big picture: Perhaps the most widely-used measures of value in the stock market is the price/earnings (P/E) ratio. Simply put, that's the market value of a company divided by its earnings.

  • When the P/E ratio is above some long-term average, the stock is thought to be expensive. If it’s below average, then it’s cheap.
  • For the denominator, it’s common to use “forward” earnings, or the earnings the company is projected to generate in the next 12 months.
  • The P/E ratio can be applied to broad market indexes like the S&P 500.

By the numbers: The S&P 500’s forward P/E touched a high of 23.6 on August 28, 2020, according to FactSet. That day, the S&P closed at 3,508. Since then, the forward P/E has trended lower, registering at 21.2 as of July 30.

  • During that period the S&P surged 25% to 4,395.

Between the lines: This dynamic has largely been driven by months of improving expectations for earnings.

  • And during the current earnings season, most companies have proven that analysts’ forecasts for earnings continue to be too conservative.

Flashback: These unusually conservative expectations for earnings can be tracked back to early 2020 when neither companies nor analysts understood where things were headed. They just knew things were bad.

  • “During the worst part of the pandemic, analysts were basically flying blind,” Liz Ann Sonders, chief investment strategist at Charles Schwab, tells Axios. “What they ended up doing in that environment was they erred on the side of just slashing estimates.”
  • Companies went on to report better-than-expected earnings quarter after quarter. But analysts were anchored in their conservative outlooks.
  • “In turn, the forward P/E over the last year has been sort of artificially high because analysts have had the estimates for the forward quarters somewhat artificially low,” Sonders explains.

Yes, but: Even at a forward P/E of 21.2, this multiple is above average. According to FactSet, the 10-year average multiple is closer to 16.2

But, but, but: Sonders cautions against putting too much weight into long-term historical averages as the macroeconomic environment has evolved greatly.

  • For one, she notes that historically low interest rates are supportive of higher valuations, a sentiment shared by the likes of billionaire Warren Buffett and even Fed Chair Jerome Powell.
  • Also, a growing share of the S&P consists of tech companies, which warrant relative high valuations thanks to their more favorable growth prospects.

The bottom line: An elevated P/E ratio alone is not a reason think stocks are doomed to fall.

  • “Sometimes high multiples are not ‘what you see is what you get,’” Anastasia Amoroso, chief investment strategist at iCapital Network, tells Axios.
  • “It is typical in a quickly recovering economy to see earnings get revised higher and beat consensus, leading to same or even lower multiples. When accounting for these higher earnings, the ‘true’ multiples may not be as expensive as they seem.”

Go deeper

Ben Geman, author of Generate
Oct 20, 2021 - Economy & Business

Telsa on track for strong Q3 earnings report following record deliveries

Expand chart
Data: FactSet and company release; Chart: Will Chase/Axios

Tesla is likely on track for another strong earnings report after logging record deliveries as the company appears to be weathering the storm of the global chip shortage.

What's next: The electric automaker will report third-quarter earnings this evening after markets close.

Felix Salmon, author of Capital
10 mins ago - Technology

Facebook's scandals have been great for shareholders

Expand chart
Data: YCharts; Chart: Axios

Facebook has been embroiled in scandal for the past five years, and while the specific allegations change over time, a central theme is constant. Given the choice between commercial and moral imperatives, Facebook always seems to choose the option that is best for the share price.

Why it matters: Facebook's stock chart supports that narrative. Since the 2016 scandals alleging that the social network was infiltrated by foreign actors trying to influence the outcome of democratic elections, Facebook's revenues — and its stock — have been soaring.

Biden to tap telecom trio for NTIA, FCC posts

Jessica Rosenworcel. Photo: Bill Clark/CQ Roll Call

President Joe Biden on Tuesday is expected to name Alan Davidson as head of the telecom arm of the Commerce Department, Jessica Rosenworcel as chairwoman of the Federal Communications Commission and Gigi Sohn as a commissioner at the FCC, according to a person familiar with the process.

Why it matters: Internet availability and affordability has been a key policy priority for the White House, but the administration lagged in tapping people for the agency posts that oversee the issues.

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