Multiple Expansion

Stocks have gone up in each of the last four years. So, they must be overvalued, right? Wrong. Stock price increases don't necessarily mean valuation multiples have to also rise.

It's a common error to believe stock multiples like the P/E ratio must expand in order for stocks to continue their climb. Many forget there are TWO parts to the P/E equation: price and earnings. Believe it or not, P/Es have actually contracted in the last several years, even as stocks gained in price! That's because earnings growth (the "E" part of a P/E ratio) has outpaced rising share prices. P/E ratios have contracted significantly over the last five years.

Our analysis indicates that when stock valuations contract three years or more, the periods directly following historically have led to explosive positive P/E expansion. (We've mentioned this idea before in our past commentary, "Three's a Charm".)

We've written extensively on the strength of earnings in the past (see our past commentary, "Consistently Too Low, Again"). Since we don't think the "E" in the P/E will drop, and evidence indicates P/E ratios are set for a rise that leaves just one option— rising stock prices.