Last Updated on 3 November, 2022 by Samuelsson
As you may already know, inflation affects equity prices in several ways. But what is the nature of the relationship between the P/E ratio and inflation?
There is an inverse relationship between inflation and the P/E ratio. Generally, when inflation is low, investors are willing to pay more for a stock, making the P/E ratio high. On the other hand, when inflation is high, investors are willing to pay less for the stock, making the P/E ratio low.
In this post, we will explain the P/E ratio and inflation, and then, discuss the relationship between the two.
What is the P/E ratio?
The P/E ratio (price-to-earnings ratio) is a financial metric for valuing a stock, which compares the stock’s current share price to its earnings per share (EPS). Also sometimes known as the price multiple or the earnings multiple, this valuation metric is used by investors and analysts to determine the relative value of a company’s shares in an apples-to-apples comparison, as well as to compare a company against its own historical record or against the broader market, such as the S&P 500 Index.
When a stock’s P/E ratio is high, it could mean that the stock is overvalued or that investors are expecting high growth rates in the future. Since the price-to-earnings (P/E) ratio relates a company’s share price to its earnings per share, companies that have no earnings or that are losing money do not have a P/E ratio because there is nothing to put in the denominator.
Inflation refers to the decline of purchasing power of any given currency over time, and this is reflected as an increase in the prices of consumer goods and services. Thus, inflation can be defined as the rate of increase in the average price level of a basket of selected goods and services in an economy over some period.
In other words, the rise in the general level of prices — often expressed as a percentage — means that a unit of currency effectively buys less than it did in prior periods. The opposite of inflation is deflation, which is a situation where the purchasing power of a given currency increases due to a decline in the prices of goods and services.
Depending on the rate of change and the way an investor looks at it, inflation can be viewed positively or negatively. An investor with tangible assets, like property or stocked commodities, may like to see some inflation as it raises the value of their assets, but someone with a lot of cash would not like inflation as it reduces the worth of their money.
The most commonly used measures of inflation are the Consumer Price Index (CPI) and the Producer Price Index (PPI).
What is the relationship between the P/E ratio and inflation?
Usually, the lower the P/E, the higher the return, and when you pay a lower P/E, you’re paying less for more earnings. As earnings grow, the return you achieve is higher. When there is low inflation, the return demanded by investors is lower, so the P/E is higher. The higher the P/E, the higher the price for earnings, which implies a lower expectation of strong returns. Thus, during times of low inflation, the quality of earnings is considered to be high, as it reflects the amount of earnings that can be attributed to actual growth in the company rather than outside factors like inflation.
When inflation is stable and modest, it means there’s a higher probability of continued economic expansion and that the central bank won’t be raising interest rates to reduce inflation. In this case, investors have lower expectations of high market returns, so they don’t price the stock highly; thus, the P/E ratio is modest. On the other hand, expectations rise when inflation is high. When inflation rises, so do prices in the economy, leading investors to require a higher rate of return to maintain their purchasing power. As investors demand a higher rate of return, they price stocks lowly, making the P/E ratio low.
How can apply this knowledge to make money from stocks?
There are a few things you can note from the relationship between the P/E ratio and inflation. When inflation is low, it may be wise to make use of a value investing approach, where you look for wrongly underpriced stocks with low P/E ratios. This approach is likely to make you more one over time than using the momentum approach where you buy stocks that are making new highs.
On the other hand, when inflation is low, it pays to use a momentum approach and pick stocks that are showing huge momentum by breaking into new highs.