What happens to PE ratios when interest rates rise?

ASX shares, as well as those overseas, have fallen significantly this year due to investor fears that interest rates are about to rise around the world.

According to Montgomery Investment Management chief investment officer Roger Montgomery, the change in mood from the US Federal Reserve “has been dramatic”.

“Back in July last year, the US Federal Funds rate was expected to be 0.3% by the end of calendar 2022. Today, the rate at that time is expected to be 1.25%,” he said in a blog post.

“The repercussions for equity investors have been impossible to ignore.”

The current war in Ukraine will only add fuel to the inflationary fire, as it could push up energy and agricultural commodity prices.

So what does this mean for ASX shares?

A common way to value a stock is to use the price-to-earnings (PE) ratio.

Montgomery set about answering a question that’s been on the tip of many retail investors’ tongues during the current volatility. What will happen to PE ratios when interest rates inevitably head north?

As one goes up, the other goes down

The incontrovertible evidence from the past, according to Montgomery, shows PE ratios shrink as interest rates move up.

“Correlation analysis, on data back to the 1980s, reveals the decline in the earnings multiple is greatest when interest rates move up from lower starting levels,” he said.

“The simple fact is, for the last 4 decades, whenever inflation or interest rates have risen, the multiple of earnings investors have been willing to pay for a share in a company has declined.”

During the current market dip, the prospect of rising rates is complemented by the tapering of quantitative easing and government fiscal support.

Everyone has fewer dollars to invest.

“Investors are simply unwilling to pay as much for a dollar of earnings as they were just 10 weeks ago.”

So which ASX shares are the best buys now?

So what sort of shares should investors buy at the moment?

Montgomery explained that when the price side of the PE ratio starts shrinking, the only way a stock can offset that is with rising earnings.

“To counteract the multiple declines, the underlying company must grow profits,” he said.

“For a company that manages to grow its earnings meaningfully, the PE contraction will prove a depressing but transitory influence on the share price.”

Even if the PE ratio itself doesn’t expand again, any ramping up of earnings will drive up the share price side of the ratio.

“Of course, this takes time for a company to achieve,” he said.

“That delay to prices going up – in tandem with earnings – provides investors with an opportunity.”

The post What happens to PE ratios when interest rates rise? appeared first on The Motley Fool Australia.

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Motley Fool contributor Tony Yoo has no position in any of the stocks mentioned. The Motley Fool Australia’s parent company Motley Fool Holdings Inc. has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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