almost 2 years ago • 2 mins
There are two variables that drive up the value of the S&P 500: the increase in its earnings per share (EPS), and the increase in its price-to-earnings multiple (i.e. the premium that investors are willing to pay for one unit of EPS). We can boil this principle down to a simple equation:
S&P price = (price / EPS) x EPS
The S&P’s price is around 4370 at time of writing, and according to Factset, it boasts an expected EPS of 230. So that gives us a P/E multiple of 4370 / 230 = 19x.
But now comes the interesting part: we can play with the variables to see how they’d impact the price of the S&P next year, as you can see in the matrix at the top of the page. So say you think investors are being overoptimistic and that the EPS will stay constant. Assuming the P/E multiple stays constant too, the S&P would fall by 9% to 3990. If the P/E multiple were to shrink to, say, 17x, the S&P’s price would crash 18% to 3570.
What’s more, we can use this matrix to understand what combination of variables could lead to a specific market move. Say you want to estimate how likely it is that we’ll see a 10% gain in the S&P. There are two ways that could happen: the EPS increases by 20% and the P/E multiple remains constant, or EPS remains constant and the P/E multiple rises to 21x. That helps you assess how realistic it is to see a given move based on your expectations for each variable.
Point being: pay close attention to each distinct variable, and your expectations of the bigger picture might start to shift. And if that bigger picture differs markedly from what the market is pricing, you might be onto an interesting trade to profit…
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