Value versus growth: Are stocks expensive right now?

Flash 45 continues the “value versus growth” discussion that began last week. To do this, we compare the historical development of price-earnings ratios (P/E ratios) in various stock markets since 1993.

The crude application of the value approach is as follows: if the current valuation – measured by the P/E ratio – is above the historical average, stocks are considered expensive and investors should stay away. This would currently be the case – albeit to different degrees – in all markets: the valuation of US stocks is currently well above the historical average, while in European markets it is only slightly above.

A common counterargument to this simple value investment rule is that the future earnings growth dynamics – which are not considered in the value approach – have structurally changed due to technological progress (internet, AI, etc.). Therefore, stocks may justifiably trade at higher P/E ratios today than in the past.

We tested this idea by plotting the long-term trend line for P/E ratios over the last 32 years. Conclusion: a long-term upward trend in P/E ratios is indeed visible in the US market, while Swiss P/E ratios have remained flat and European P/E ratios have even declined. Perhaps different valuation rules really do apply in the Wild West. Perhaps – we shall see.

When considering the question of the “correct” or “fair” P/E ratio, it is important not to ignore investment alternatives. The attractiveness of a 5% equity earnings yield (corresponding to a P/E ratio of 20) must be assessed very differently when the yield on 10-year government bonds is 0% or 4%. One would expect the equity return demanded by investors to fluctuate with the interest-rate environment.

Finally, a historically above-average P/E ratio can theoretically normalize either through rising corporate earnings or falling stock prices. History shows that after periods of significantly above-average valuations, the latter scenario usually occurs.