The P/E RatioThe price-to-earnings (P/E) ratio is a simple abstraction, a multiplierused to compare the price of a stock with the earnings of the company. In the market crash of 2008, stock prices dropped dramatically from their former heights, but as the P/E ratio demonstrates, the earnings reported by the companies that underlie those stocks dropped much further.

From the end of World War II to the late 1990s, the P/E ratio of the S&P 500 hovered between 10 and 20. This range delivers, respectively, from 10% to 5% corporate earnings on the price paid for the stock.Around 1997, however, the P/E ratio reached unusually elevated numbers, which remained elevated until 2002. Part of the accelerated rate was due to a surge of Boomer earnings and investments driving up the overall price of stocks (just as home prices were boosted by the surge of Boomers in the 1980s).

Nonetheless, after the stock market crash which ended in 2002, the P/E ratio remained near 20 (see darkened bar on chart) until the financial crisis reached its apex in the last quarter of 2008, when the P/E ratio abruptly jumped from 25 to 60 as stock prices failed to adjust to the drop in earnings. In 2009, earnings fell further and stock prices continued to rise (as risk takers returned, bringing more money into the market to vie for the same number of stocks), until the P/E ratio peaked at a multiplier of 122 in the second quarter of 2009, with annual earnings of only .82%.

Stock prices set adrift

These numbers were fueled by irrational optimism among investors, not by legitimate pricing expectations about the future income of these companies. After dramatic stock price drops in the third and fourth quarters of 2009, the P/E ratio at the end of 2009 was approximately 23: more realistic but still too high for long-term stability.

By mid-2010, the ratio had fallen to 16, right in line with its historic link to earnings. By mid-2011, the P/E ratio had dropped below this average, and was hovering between 11 and 15, thanks to tepid earnings and a continuing lack of confidence about growth in the economy. [For more on consumer confidence, see the first tuesday Market Chart, Homebuyers feel ready and willing to buy, but not financially able.]

This return to market norms in 2009 and early 2010 came about due to a combination of gradually rising stock prices and dramatically rising earnings. Provided the market continues to gradually right itself, investors will soon become more tolerant of risk, and the economy as a whole will benefit.

As time passes, these investors will also come to realize that there will not be another boom to rival the 1990s and will adjust to the reality of the present situation, which includes a rise in interest rates over the next two decades as U. S. GDP increases. Investments will reflect this realization, keeping the P/E ratio between 10 and 20, and the percent earnings between 10% and 5%. Thus, a measure of stability will return to the stock market.

Real Estate Applications

The real estate and stock markets are not the same, of course, but thoughtful investors will pay attention to their relationship. There are some notable distinctions to be made between the two.

Real estate investors will never be satisfied with the 5% returns offered by stocks when the P/E multiplier is 20. Property owners certainly do not buy real estate based on a 5% cap rate – a NIM of 20 – the current P/E ratio buyers of stocks are settling for. Problems that plague stocks, like spurts of inflation and short-term interest rates, are far less likely to affect properly mortgaged real estate.

Real estate investment pricing, in turn, is driven by the components making up the caprate investors use to set real estate prices. 2.5% to 3.2% of the return from an investment in real estate must provide for the annual recovery, over 30 to 40 years, of capital allocated to improvements on the property due to their inevitable physical deterioration (called depreciation).

Capital recovery problems are inapplicable to investments in companies listed on the stock market. They sell products which can be changed to suit the current needs and location of the population – unless, of course, they are real estate investment trusts (REITs). [For more on REITs, see the first tuesday Market Chart, REIT investment: playing the real estate game from the sidelines.]

The cap rate and converse the P/E ratio

In the stock market, the price paid by buyers is expressed in terms of its relationship to the company’s earnings, as a P/E ratio. Conversely, real estate prices are offered (and paid) based on the rate of return sought by the buyer, called a cap rate. It is only then that a NIM—the real estate equivalent to a P/E ratio — is determinable.

The NIM is easily produced: it is simply the reciprocal of the cap rate. For example, earnings of 5% (a 5% cap rate) will indicate a P/E ratio – NIM – of 20. Remember: real estate buyers evaluate the property’s return on their investment by use of the cap rate; stock market investors determine their success by the ratio of earnings to quoted price.

More importantly, stocks represent stored wealth, especially the accumulated wealth of senior citizens. These seniors will soon begin to pull cash out from this store of wealth as they retire. Current trends in the stock market and future interest rates expectations are not likely to inspire a great deal of investment momentum activity in the near future, even from the most optimistic. [For a review of current and historic home sales, see the first tuesday Market Chart, Home sales volume and price peaks.]