Asset Pricing: Dissecting Trends and Changes in the P/E Ratio of the S&P 500 Index

Abstract

Rational investors will seek compensation for taxes and transaction costs when estimating the expected return of a given investment. Hence, changes in investor taxes and transaction costs should have an influence on the expected return on equities, and hence the warranted price-to-earnings multiple of the equity market. Rational investors will also recognize that in times of high inflation, the current cash cost of investments is much higher than the historical non-cash accounting depreciation charge. Hence, the ratio of free cash flow to accounting profits becomes lower in high inflation scenarios. Since cash flows is the ultimate driver of share prices, a rational investor will assign a lower multiple to accounting earnings in times of high inflation than in times of low inflation. Furthermore, since taxation is based on nominal returns, rational investors want proper compensation. Therefore, the expected pre-tax nominal return is an augmented positive function of inflation. The purpose of this paper is to explain trends and changes in the P/E ratio on the S&P 500 Index by estimating trends and changes in the warranted P/E ratio. Two models are developed for this purpose: An integrated present value model and a standard regression model. Both models are able to explain observed trends and changes in the P/E on the S&P 500 Index over the period 1980 to 2014, but both models fails to explain the high P/E multiples at the height of the IT/TMT-bubble in 2000.