Every time the stock market falls, media headlines suggest reasons to wait before buying (i.e. trying to time markets).
In early 2025, the S&P 500’s price-to-earnings (P/E) ratio was 27, which was the highest it had been in 25 years, excluding a short period during the 2021 COVID lockdowns. While this implied that US stocks were expensive and future returns would be low, bank research departments held a bullish outlook on future returns.
During the “tariff tantrum” in April, the S&P 500 fell nearly 20% from its peak pulling its P/E ratio down to 21 which is barely above its historical average over the last last 30 years. (Source: Bloomberg)
Suddenly pundits and the media switched their tone to caution. Headlines like “wait to buy because P/E ratios fall to 16 during a recession” emerged.
Since then, markets have recovered their losses and those who waited missed yet another buying opportunity.
Could it be that the P/E of the S&P 500 should be higher today than its historical average? We give some arguments as to why it should be and, therefore, that investors should be happy buying with a P/E in the 20s.
Below is a chart of the rolling 20-year P/E on the S&P 500 going back to 1947. The average was around 15 from 1947 to 2000. But after that, we see a jump to a new higher normal average of around 20.
The primary drivers of P/E are: a) growth rate, b) return on investment (ROI), and a distant third, c) interest rates.
Many investors know about growth rate but ignore ROI when judging valuations.
Return on investment determines how much cash flow is available to invest in growth. It also determines how much cash flow is available to return to shareholders.
Below is a chart showing our estimate of the historical return on equity (as a proxy for ROI), for the S&P 500. We can see that the trend has been upward, from 11-12% in the 1970’s up to 16+% today. This is a huge improvement which should commensurately drive P/E upward.
What’s driving this increased return?
Value has shifted from tangible assets like factories, to intangible assets like patents and software code. And this shift has resulted in higher profit margins. For example, Microsoft has 35% net margins, compared to 5% for GM.
Largest companies have near monopoly power and can sustain high ROIs. For example, Apple’s iPhone is a platform with >1 billion locked in users compared to Exxon Mobil selling a commodity like oil.
Tailwinds to growth from AI and cloud computing to the tech sector, which is much larger than in the past and has higher ROI’s than other sectors.
Interest rates are also lower today, compared to the 1970’s, but this has a smaller impact than the factors above.
A friend who studied finance at Columbia University shared the table below justifying P/E ratios at different ROI levels. We can see that as ROI goes up, so must P/E.
The remaining factor to estimate is earnings growth. Stocks deliver returns to shareholders through 2 channels: growth and return of capital (dividends + buybacks).
Since 1970, the inflation adjusted earnings growth for the S&P 500 was ~2% while returns of capital through dividends and/or buybacks has averaged 3.5%. And currently markets are pricing in almost 2.5% inflation for the next 10+ years. Adding up these components gives expected growth of 8% per year.
If one takes the 16-18% ROI’s that the S&P 500 has averaged over the last decade, with 8% expected growth, they together justify a P/E ratio in the bottom right quadrant of the table above, or at least in the low 20’s (rather than the high teens of years past).
“This time is different” can be the most dangerous words in investing. But we also shouldn’t automatically accept the relevance of historical averages without questioning their underlying assumptions. Given the change in the economics of today’s largest companies, waiting for P/E ratios to return to historical averages may lead to lost returns.
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