I’ve been reading a lot lately that  the stock market is priced just right because earnings growth is expected to be high, growing at double digits. But earnings growth is not the sole determinant of stock price. Investor preference for risk versus return is the primary determinant, as reflected in the price/earnings (P.E) ratio.

Setting a P/E ratio

P/E is the price you’re willing to pay for each dollar of earnings. The P/E on the stock market is currently 30, meaning that investors are paying $30 for each dollar of current earnings. Why would anyone pay $30 in order to get $1 back? Because investors are buying the stream of future earnings. That $30 buys participation in all future earnings, with high expected growth on key stocks shown as follows.

Sure, expected growth is high. But how do we know that $30 is the “right” price to pay? We need to estimate what our return will be based not just on earnings growth but also on changes in P/E – P/E expansion or contraction. P/E reflects investor appetite for risk. The current P/E is very high relative to history, implying high willingness to take risk, but if investors become more cautious P/Es will contract.

Expected returns

The following table shows next year’s returns for various combinations of earnings growth and ending P/E.   

Let’s focus on the high earnings growth columns on the far right, growing between 14-18%. If P/Es remain at 30 or expand to 35, the 2026 return on stocks will range between  15-39% -- very good. But if P/Es contract down to 25 or 20, stocks will decline between  1-23% -- not good – despite high earnings growth.  And if P/Es decline all the way down to their historical level of 15, stocks will lose 40% even though earnings are growing nicely; high earnings growth will not save the day.

Conclusion

The point is that high expectations for earnings growth do not justify high P/Es. Investor behavior  determines P/Es. Our return expectations need to hinge on our expectations for P/E expansion or contraction, rather than earnings growth. Which do you see happening? Will P/Es contract or expand?

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