Im continually reading investors comparing a stocks PE for the last five years to the current PE and concluding that the stock is cheap because the PE is now lower.

The big issue with this analysis and conclusion is of course bond yields are now much higher. The possible impact on valuations is significant, as per below example,

One stage DDM : Po= D1/(k-g) or alternatively PE= payout/(k-g)

K is cost of capital which is mainly determined by the risk free rate and equity risk premium (ERP).

Keeping payout, ERP and growth constant, and adjusting the US 10Y bond for the last 5 years ie 1.8% (according to trading view) and the spot rate 4.2% we get…

PE=.7/(.06+.018-.03)= 18.4

PE=.7/(.06+.042-.03)= 11.3 or 39% lower

You can play around with the variables but they don’t move too much, imo, under reasonable assumptions.

I said possible because like a lot in finance, nothing is certain. Also spot to spot comparisons on anything carry underlying assumptions that have to be considered, like, is it correctly priced in at either end.

Secondly some companies will see growth change both + and – given the move in bonds and what that implies for sectoral earnings. For the long dated growth companies, however, the Pe’s used now should be much lower than the last 5 years. You can of course use your own forward assumptions into the model and see horror or a bargain. That what’s makes a market but i would point out historic PEs are now just that.. historic. A few stock prices have adjusted, imo, but not many to the full extent.