The forward P/E ratio for the S&P 500 over the next 12 months is hovering at just 21x, which looks pretty reasonable considering the benchmark’s current P/E ratio of 28x. Experts caution that this does not mean stocks are cheap. Data from FactSet shows that the spread between two P/E ratios is rarely this wide, except in extreme market cases like in 2000. This is a sign that investors are seriously expecting a parabolic move in earnings next year, and any shortfall could cause a market pullback. Whether companies can live up to these big profit expectations will become clearer when second-quarter earnings season begins next week. Companies are likely to provide forward guidance in response to these results. What the spread shows: Stocks aren’t cheap Valuation spreads are important because they indicate how much of the market’s valuation case is tied to future earnings growth. “The numerator of both P/E ratios is the same, and it boils down to the difference between LTM and NTM returns,” Aswath Damodaran, a professor of finance at New York University’s Stern School, said in an email to CNBC. LTM refers to the past 12 months’ revenue and NTM refers to the expected revenue for the next 12 months. The spread of infection itself may not be a warning. The bigger question is whether Wall Street’s earnings forecasts are too optimistic. “A little algebra shows that spreads are a direct measure of expected earnings growth,” Itzhak Ben-David, a finance professor at Ohio State University’s Fisher College of Business, told CNBC via email. Simply put, widening spreads indicate that today’s valuations are heavily dependent on companies delivering better returns over the next year. Ben-David said that makes today’s setups demanding by historical standards. Since 1989, he said, the median real growth rate in S&P 500 earnings per share has been about 8% per year, and the level of growth implied by today’s spreads has occurred less than once every five quarters. He added that in all of these cases, most of the recoveries were from periods of weak revenue: 1994-1995, 2003-2004, 2009-2011 and 2021-2022. “What the market is pricing in today is different: growth of this magnitude starting with profits that are already at record high levels,” he said. “Wide spreads, therefore, do not indicate that the market is cheap on futures returns. It indicates that prices are only reasonable under earnings outcomes that have essentially never occurred in current data, except for the post-recession recovery.” Harvard economics professor John Campbell made a similar point. “Mechanically, this spread reflects the fact that analysts are expecting unusually strong short-term earnings growth,” Campbell said in an email. “While they are often right about short-term earnings trends, it’s important not to assume that high short-term earnings will continue indefinitely into the future.” Campbell, who co-authored a paper with Robert Shiller on valuation ratios and long-term stock market returns, said a decline in forward P/E ratios should not be taken as evidence that stocks are fairly valued. “A lower and therefore more reasonable future P/E ratio does not mean that today’s higher stock price is justified by the present value of all future profits (or dividends). It is better to use historical average earnings, similar to the CAPE ratio, to determine the price level. That approach shows that today’s stock price is unusually expensive,” he said. The cyclically adjusted price-to-earnings ratio (CAPE ratio), popularized by Professor Shiller of Yale University, is calculated by dividing a stock’s current price by its average inflation-adjusted earnings over the past 10 years, and is considered ideal for long-term market timing. By comparison, forward P/E ratios are based on a relatively short period of 12 months, making them more suitable for short-term market analysis. The role of analyst forecasts Ben-David also highlights the role of analyst forecasts. Ben-David said that when the gap has been this wide in the past, including in 2000, it has been narrowed by performance disappointments, multiple rounds of compression, or both. “The forward P/E ratio looks exactly ‘reasonable’ because it takes into account earnings that have not yet occurred,” Ben-David said. In a 2024 working paper with Alex Chinko, he found that analysts typically set price targets by multiplying the expected earnings per share price by a trailing P/E ratio. The study examined 513 sell-side reports on large public companies from 2003 to 2022 and concluded that most analysts use trailing P/E ratios rather than discount rates. “Earned earnings are the driver of valuation and are not an independent check on it, so a reassuring forward P/E ratio is not evidence that the market is undervalued. It reaffirms the optimism built into the forecast,” he said. Other academic research questions how much weight investors should place on future earnings forecasts. A research 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. This means that a low forward P/E ratio does not automatically reassure investors. “We find no evidence that either ratio predicts growth persistence. Overall, these results indicate that trailing P/E exceeds future P/E in predicting future growth, and that investors may gain further insight into a company’s future growth through trailing P/E,” Gao and Wu wrote in their 2008 paper.
