The stock market looks pretty cheap based on future earnings expectations. Don’t be fooled
The S & P 500 trades at just 21 times expected earnings over the next 12 months, a forward price-earnings ratio that looks quite reasonable considering the benchmark’s trailing P/E is currently 28. It doesn’t mean stocks are cheap, experts warned. The spread between the two P/E ratios is rarely this wide except at market extremes like back in 2000, FactSet data shows. It’s a sign that investors are really expecting a parabolic move in earnings in the coming year and any shortfall could cause a market pullback. We’ll get a clearer idea of whether companies can live up to these big profit expectations when second-quarter earnings reporting season kicks off next week. Companies are likely to give forward guidance with those results. What the spread shows: Stocks aren’t cheap The valuation spread matters because it shows how much of the market’s valuation case is tied to future earnings growth. “The numerator in both your P/E ratios is the same, boiling down the difference to that between LTM and NTM earnings,” Aswath Damodaran, professor of finance at NYU Stern, said in an email to CNBC. LTM refers to earnings over the last 12 months, while NTM refers to expected earnings over the next 12 months. The spread itself may not be the warning. The bigger question is whether Wall Street’s earnings forecasts are too optimistic. “A little algebra shows the spread is a direct measure of expected earnings growth,” Itzhak Ben-David, a finance professor at Ohio State University’s Fisher College of Business, told CNBC in an email. To put it simply, the wider spread shows that today’s valuations depend heavily on companies delivering stronger earnings over the next year. Ben-David said that makes today’s setup demanding by historical standards. He said median real growth in trailing S & P 500 earnings per share has been about 8% per year since 1989 and growth at the level implied by today’s spread has happened in fewer than one in five quarters. All of those cases, he adds, were mostly rebounds from periods when earnings had collapsed, namely periods between 1994 and 1995, 2003 and 2004, 2009 and 2011, and 2021and 2022. “What the market is pricing in today is different: growth of that magnitude starting from earnings that are already at record highs,” he said. “So, a wide spread doesn’t tell you the market is cheap on forward earnings; it tells you prices are reasonable only under an earnings outcome that, outside of post-recession rebounds, has essentially never occurred in the modern data.” John Campbell, a Harvard University economics professor, made a similar point. “Mechanically, this spread reflects the fact that analysts expect unusually strong near-term earnings growth,” Campbell said in his email. “They are often right about near-term earnings developments, but it’s important not to think that high near-term earnings will continue into the indefinite future.” Campbell, who has co-authored a paper with Robert Shiller on valuation ratios and long-run stock market returns, said the lower forward P/E should not be taken as proof that stocks are fairly valued. “The lower and therefore more reasonable forward P/E does not imply that today’s high stock prices are justified by the present value of all future earnings (or dividends) – to judge the level of prices, it’s better to use historical average earnings as the CAPE ratio does and that approach says that stocks are unusually expensive today,” he said. Popularized by Yale’s Shiller, the cyclically adjusted price-to-earnings ratio, or CAPE ratio, is calculated by dividing a stock’s current share price by its average inflation-adjusted earnings over the past decade and is considered ideal for long-term market timing. In comparison, forward P/E relies on a comparatively shorter period of 12 months making it more favorable for short term market analysis. Role of analyst forecasts Ben-David also highlights the role of analyst forecasts. In the past, when the gap was this wide, including 2000, Ben-David said the spread closed through earnings disappointments, multiple compression or both. “The forward P/E looks ‘reasonable’ precisely because it credits earnings that haven’t happened yet,” Ben-David said. In a 2024 working paper with Alex Chinco , he found that analysts typically set price targets by multiplying forecasted earnings price per share by the trailing P/E. The study examined 513 sell-side reports on large public companies from 2003 through 2022 and concluded that most analysts used a trailing P/E ratio rather than a discount rate. “Expected earnings are the engine of valuation, not an independent check on it. So, a reassuring forward P/E is not evidence that the market is cheap; it restates the optimism embedded in the forecasts,” he said. Other academic research also questions how much weight investors should give to forward earnings estimates. A working paper by Zhan Gao and Wan-Ting Wu, directly compares forward P/E and trailing P/E and finds that trailing P/E can outperform forward P/E in predicting future growth, which means that lower forward P/E should not automatically reassure investors. “No evidence is found that either ratio predicts the persistence of growth. Overall, these results indicate that the trailing P/E outperforms the forward P/E in predicting future growth and that investors may gain further insight into firms’ future growth via the trailing P/E,” Gao and Wu wrote in their 2008 paper.
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