The Corner for Sept. 27, 2013

What is the price-to-earnings (P-E) ratio of the Dow Jones Industrial Average (DJIA)? First of all, let’s get an understanding of what price-to-earnings ratio is. The relationship that exists between the earnings-per-share and market price is the P-E. If a stock is selling at $25 and earnings-per-share are $2, its P-E is 12½ to 1 — the stock is then selling at 12½ time earnings. Should the stock rise to $40, the P-E ratio would be 20. Conversely if the stock drops to 12, the P-E would be six.

The P-E of the DJIA, popular yardstick used to value the market, is the P-E earnings ratio of the DJIA. It is calculated by dividing the current price of its 30 stocks by the earnings-per-share of the component companies over the latest 12 months.

When the P-E ratio is high, the market is considered pricey. If it’s low, it’s considered undervalued. Over the years, the Dow’s P-E has averaged 15. When the P-E has ventured far out of this range, it has signaled market bottoms and tops.

It got as high as 133 in mid-1983, when the bull market that began the previous August went into a correction that lasted until August of 1984. It rose to 22.1 in August of 1987. By June of 1992 the P-E soared to 40.6. At that time, the Dow’s earnings-per-share had plummeted due to many component companies that were restructuring and suffering losses.

The P-E fell to 11.2 in October 1990 — yet another indicator that the market was bottoming. Despite the market run up in 1995, the Dow’s P-E stayed around 14. This was due to the explosion in profit growth that was occurring simultaneously with the rally. Thus, as profits increase along with the DJIA, the P-E is able to stay constant.

The P-E of the S&P 500 Index, which is an index of 500 stocks, has historically averaged around 14, and has generally ranged for a low of nine to a high of 66 during the recent financial crisis.

Currently the DJIA P-E is 16.1.

Quote of the Week: “Make use of time, let not advantage slip.” — Shakespeare

Bart Ward is the chief executive officer of Ward & Co. Ltd., an Anoka-based registered investment adviser – specializing in the management of stock and bond portfolios in companies which are listed on the NYSE.

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