PE Ratios and a Market Correction

Scott Francis looks at the link between PE ratios and market returns.
By · 26 Oct 2023
By ·
26 Oct 2023 · 5 min read
comments Comments
Upsell Banner

One of the great Warren Buffett quotes encourages us when thinking about buying shares: “to be fearful when others are greedy and to be greedy only when others are fearful.”

This is not easy to do. 

When people are fearful, so are the headlines and stories about what might be ahead. It is hard to be buying a volatile asset like shares surrounded by bleak headlines and stories.

Indeed, over the past 15 years, we have had two significant downturns to exploit as investors, the nearly 50% fall in the value of shares during the Global Financial Crisis, and the 40% fall during the Covid downturn of 2020. In hindsight, we can see clearly that buying Australian shares in early 2009 when the ASX All Ords fell to 3300 points, or buying shares in 2020 when the ASX All Ord fell to 5100 points, would have been lucrative on the bask of strong dividends, franking credits and capital growth. However, at the time, it was a period of frightening headlines that made it difficult to move money from the relative security of cash.

How Big an Opportunity is the Current Correction?

With the Australian market now in ‘correction’ territory, meaning that the market has fallen 10% from market highs, the question might be, is this a time to be greedy?

Simply put, a 10% fall in the value of Australian shares means that, on average, they are now 10% cheaper to buy than they have been. There is a 10% off sale on Australian shares. This is not a compelling reason to buy – however for those investing regularly, for example seeing compulsory superannuation contributions going into a superannuation account – the lower prices mean that a regular contribution is buying a little more.

There is a piece of investment maths that I find fascinating, relating to the ‘being greedy when others are fearful’. Let’s consider an investor who invests $1000 of shares into company X at a share price of $10. X’s share price falls to $5, so they invest another $1000. What is the average price of the shares in company X? 

At face value I always think it will be $7.50 – the average of the two buy prices. However, because twice as many shares are purchased at the $5 price, the average price of shares is lower, at $6.67. 

Buying more shares at lower prices is a powerful way to decrease the average price of an asset.

Perhaps a 10% market drop is not a buying opportunity by itself, however, those people investing regularly will see the average buy price of their portfolios fall by continuing to make regular investments. At the moment, each superannuation investment, for example, is buying 10% more growth assets than when the market was around the high.

The Link Between PE Ratio and Returns

To help understand market downturns, there is an interesting link between PE ratios and returns, that Jeremy Siegal, USA academic and author of the book ‘Stocks for the Long Run’ talks about. 

Rather than consider the PE ratio (calculated by dividing the price of a company by its earnings), we can invert it. If we invert the PE ratio of the market, we find the earnings yield (earnings divided by the price of a company). Earnings yield is not dissimilar to the dividend yield, except that it is for the total company (or market) earnings, not just the company dividend. Effectively it tells us for every dollar invested, what the company's earnings are. A 6% earnings yield says that for every dollar invested the company will generate 6 cents (6%) of earnings each year.

Based on USA share market data, Siegal describes the long-run real (after inflation) returns from investing in shares as being reliably around 6.5 to 7% per year. In a recent interview he remarked that despite Covid and the GFC, the past 30 years had an after-inflation return of 6.7% per annum, the same as the return from 1802 to 1992 (this is based on the USA market).

If you start with an average PE ratio of around 15, we can see that the inverse of this (1/15) = 6.7%, or an earnings yield of 6.7%.

A company’s earnings are, in very rough terms, their income less their expenses. If we assume that a company grows both their income and expenses each year at a rate equal to inflation, then earnings should also increase with inflation. On that basis, the earnings yield should be an approximation of the long-term after-inflation return. And, as Siegal points out, the long-run market average PE ratio of 15 in the USA market has equated to a long-run after-inflation return of 6.7% in a reliable fashion. 

The PE Ratio and Earnings Yield in a Correction

One of the challenging elements of the PE ratio is finding a value for it at any point in time – different calculations and assumptions can make it hard to pin down an exact figure.

Interestingly, Vanguard, providing the portfolio characteristics of their portfolio based on the ASX300 index, quotes a current PE ratio of 15.18 for the underlying index of shares. Calculating that to an earnings yield, and it gives a value of 1/15.18 = 6.6%. 

When the market was 10% (roughly) higher, the PE ratio would have been 16.69 (assuming that market earnings have not changed). At a PE ratio of 16.69 the earnings yield would have been 1/16.69 = 6.0%.

While the increase in earnings yield from 6.0% to 6.6% is not dramatic, it does highlight the way that the calculations of earnings yield might provide useful information for investors. 6.6% is a more attractive earnings yield than 6.0%.

Earnings Yield in a Downturn – looking back on the Global Financial Crisis (GFC)

According to, the PE ratio of the Australian market around the low point of the GFC (Feb 2009) was 8.7. This equates to an earnings yield of 11.5%. On face value this seems significantly more attractive than the 6.6% earnings yield on offer now – the question is, what return did investors who held their nerve and invest receive?

The ASX200 accumulation index, which measures both price movements and dividends, was 22,000 in February 2009. It is now 85,800 points – not quite quadrupling an investment in Australian shares made at the low point of the GFC, but getting very close.

For those ‘greedy’ when the earnings yield of the Australian market was around 11.5%, the subsequent rewards have been significant.


Which brings us back to where we started – the current market correction of around 10%. For those with little money to invest, or who are investing regularly, their investment is now buying 10% more. One way of thinking about market value might be in taking the PE ratio, and turning it into the earnings yield for a market. It communicates that, as prices fall, the earnings yield rises – and all else being equal a higher earnings yield is more attractive. Putting this to the test during the GFC downturn, and we see that an unusually high earnings yield of 11.5% translated into strong future returns. In the challenges of being ‘greedy when others are fearful’, perhaps keeping an eye on the earnings yield of the market is a reasonable tool to use.

Google News
Follow us on Google News
Go to Google News, then click "Follow" button to add us.
Share this article and show your support
Free Membership
Free Membership
Scott Francis
Scott Francis
Keep on reading more articles from Scott Francis. See more articles
Join the conversation
Join the conversation...
There are comments posted so far. Join the conversation, please login or Sign up.