Tracking fundamental value drivers: A look at US and European stock market trends

By Tim Koller with Jelle Duizendstraal, Marc Goedhart, and Vartika Gupta, CFA

People often wonder whether fundamental market valuation levels, as reflected by aggregate price-to-earnings (P/E) ratios, are an arbitrary outcome of market dynamics.

The answer is that the movement of P/E ratios over time effectively reflects the fundamental performance of companies. To demonstrate this close association, we estimated a fundamental P/E ratio for the US stock market for each year from 1962 to 2023, following the equity value driver formula: Value = net income  X (1 – growth/return on new equity)/(cost of equity – growth).

Using this formula, we estimated what the P/E ratios would have been for the US stock market for each year, had they been based on these fundamental economic factors. Despite periods of extremely high economic growth in the 1960s and 1990s, as well as periods of low growth and high inflation in the 1970s and 1980s, and again in the early 2020s, the exhibit below shows how a simple fundamental valuation model closely fits the stock market’s actual P/E levels over the past decades.

The overarching conclusion that can be drawn is that, by and large, the US stock market has been reasonably priced, with the median P/E ratio hovering around the fundamental P/E ratios estimated by our model. A similar analysis of the European stock markets yields similar results, although P/E ratios are generally lower than those of the US as a result of lower growth and return on capital.

Importantly, the aggregate P/E ratio, the metric most frequently referenced in the news media, can be skewed by very large, highly valued companies and is, therefore, not consistently a reliable indicator of the pricing level of most companies.

In addition, since 2010, actual P/E ratios have been slightly higher than in previous decades, which is partly attributable to steadily increasing returns on capital, as well as excess cash balances held by large companies (cash has a high implied P/E given that it carries little after-tax interest). We find that correcting for the excess cash balance in corporate P/Es typically lowers the ratio for the market as a whole by one to two points (see, for example, R. Gupta, B. Jiang, and T. Koller, “Looking behind the Numbers for US Stock Indexes,” McKinsey on Finance, no. 65 (January 2018): 11–15).

To summarize, over the past six decades, economic fundamentals have been driving both the stock market as a whole and individual sectors and companies. It also applies outside the United States, particularly in Europe. At times, markets deviate from fundamentals and experience bubbles, but these tend to be short-lived and isolated to specific sectors or companies.

For more insights into the fundamental drivers of value, read Chapter 6 of the new 8th edition of Valuation. Order your copy here.