Dale Jackson

Personal Finance Columnist, Payback Time

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After years of massive advances, stock markets are taking back some of their gains.

Regardless if you’ve listened to the experts and diversified your retirement portfolio, you are probably feeling the pinch. We shouldn’t be surprised but when you’re in the midst of a correction, it might seem like a free fall.

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In some speculative sectors, such as cryptocurrencies, it is certainly a free fall. But for businesses that consistently generate earnings, it’s merely a time for markets to reset and find their footing in the wake of an inflation-fighting interest rate tightening campaign by central banks.

That gives shareholders a chance to review earning expectations, validate what they already own, and potentially buy more stocks at a discount if they have the cash.

Compared with the last major selloff at the onset of the pandemic, the corporate earnings picture has dampened but is coming into light. The latest note from strategists at Sanford C. Bernstein acknowledged that expectations need to be cut as rates rise, but said “it is possible that the market has overshot the extent of this.” 

Analyst reports are mixed on how much earnings expectations will need to be tempered. According to the latest tally by earnings tracker Refinitiv, 61 per cent of companies listed on the S&P 500 have already lowered their earnings expectations for the current quarter.

Still, Refinitiv reported earnings growth for the S&P 500 in the current quarter is expected to increase 14.4 per cent compared to the same time last year, with consumer discretionary names leading the way at 52.3 per cent.

Measuring corporate earnings against stock prices

What does this mean for the stocks in your portfolio? The price of a stock, at any point in time, is a reflection of the market’s confidence in a company’s ability to grow earnings. Each stock has an intrinsic or fair value based on the company’s future earnings. The trick to finding a bargain is determining if the current price is below its intrinsic value. It’s called value investing and it has made Warren Buffett, Warren Buffett.

Value investors like Warren Buffett use several metrics to determine how a stock is trading in relation to its intrinsic value but the most common example is the price-to-earnings (P/E) ratio.

The simple formula for determining a P/E ratio is dividing a company’s current stock price by its earnings per share. If shares are trading at $100, for example, and earnings per share is $5, the P/E ratio is 20 times.

The big Canadian banks, as examples, are currently trading at P/E multiples of around 10 times earnings -- well below historic levels.

A low P/E ratio can generally be thought of as a ‘buy’ signal and a high P/E ratio is generally a ‘sell’ signal but determining the dividing line depends on a lot of factors including economic conditions and the individual company’s history of meeting earnings targets. Reading a P/E ratio is also much more difficult during market transitions such as the one we are in now because earnings expectations are in flux.

P/E ratios can be calculated using trailing (or past) earnings or forward earnings expectations issued by the company.

The trailing P/E for the entire S&P 500 is currently 18.7 times earnings, according to Refinitiv, and its forward P/E is currently 17.1 times earnings -- even after expectations were lowered.

Market analysts and investment advisors with expertise in reading financial statements will use whichever metric is most accurate depending on the specific company and market climate. A P/E ratio is always subject to interpretation.

Most financial websites and trading platforms provide updated P/E ratios for individual stocks, along with credible analyst reports for investors who want to keep track. Most also list current dividend payouts to help investors find companies that deliver generous and consistent dividends, so you can get paid while you wait for the stock price to rebound.

Payback Time is a weekly column by personal finance columnist Dale Jackson about how to prepare your finances for retirement. Have a question you want answered? Email dalejackson.paybacktime@gmail.com.