When the market is up, people start to worry about valuations…

And one of the most popular valuation metrics is the price-to-earnings (P/E) ratio.

The calculation is simple. Divide the price of a stock by its earnings per share.

Right now, the S&P 500 Index trades at a trailing 12-month P/E ratio of more than 30 times. Historically, that’s high. But as we’ll explain, this one metric doesn’t tell the full story…

Here’s what the P/E ratio for U.S. stocks looks like on a longer-term basis…

“Bears” often cite high P/E ratios as a reason for caution…

Federal Reserve Chair Jerome Powell recently got on this bandwagon. Back in September, he sent the market tumbling by noting in a speech that “equity prices are fairly highly valued.”

But it’s not so cut-and-dried on how important the P/E ratio is…

I talked with my colleague and Chaikin Analytics founder Marc Chaikin for his take on the importance of the P/E ratio – particularly its role in determining Power Gauge ratings.

At Chaikin Analytics, we use the Power Gauge to analyze the markets. This key tool gathers investment fundamentals and technicals into a simple rating of “bullish,” “neutral,” or “bearish.”

Marc said that in the 1980s and 1990s, P/E ratios were highly relevant in identifying attractive stocks. Price-to-sales (P/S) ratios later took priority… then yielded to earnings growth and momentum.

Today, the Power Gauge uses the projected P/E ratio within the Earnings category, which is just one of the categories it looks at to determine a stock’s rating. And it ranks that ratio on a relative basis versus other stocks.

If the projected P/E ratio drifts upward, that isn’t automatically a bad sign. What matters is how the ratio ranks versus other stocks – not the absolute number.

Of course, people love to talk about P/E ratios. And they usually infer that a high P/E ratio is bad… and that a low P/E ratio is good.

But that doesn’t always hold true in practice. Let’s look at a couple of examples…

Two Vastly Different Moves Following ‘Low’ and ‘High’ P/E Ratios
First is athletic apparel company Lululemon Athletica (LULU)…

As a brand, Lululemon is a massive success.

The company’s clothes are everywhere. And folks love them…

When asked whether they considered themselves loyal customers, 83% of Lululemon’s customers said “yes.”

And 8 out of every 10 Lululemon customers join the company’s membership program. As of 2024, that program had 22 million members.

To an investor, that looks like a formidable competitive moat.

And going into 2024, Lululemon’s stock looked attractive based on its historical P/E range…

As you can see, its P/E ratio had dropped from almost 90 times to around 64 times. Investors might have thought they were getting a bargain.

But consider how Lululemon’s stock ended up performing…

It fell by about 25% in 2024. And it ended 2025 down roughly 46%.

As it turns out, Lululemon’s products had become stale and predictable – particularly in its core U.S. market, where sales were declining.

And buying the stock just because its P/E ratio looked cheap would’ve lost you a lot of money.

A different example is Big Pharma firm Eli Lilly (LLY)…

Lilly’s drugs Zepbound and Mounjaro generated $10.1 billion in the third quarter of 2025 alone. This made tirzepatide – which is behind both Zepbound and Mounjaro – the world’s bestselling drug. Lilly now controls about 58% of the obesity drug market.

But Lilly looked expensive in January 2024. Its P/E ratio had more than tripled – from less than 30 times to more than 100 times. A skeptic would’ve said you were paying way too much for the stock.

Take a look at this chart…

Since then, Lilly has soared. The stock jumped by about 32% in 2024. And it closed out 2025 up roughly 40%.

These examples reveal something important…

There’s More to a Good Investment Than the P/E Ratio
A low P/E ratio doesn’t guarantee a good investment. And a high P/E ratio doesn’t mean you should automatically avoid a stock.

Business quality and growth potential matter more than one simple valuation metric.

Plus, some stocks are cyclical – think automakers, homebuilders, and industrial companies.

Cyclical stocks flip that “low P/E ratio” versus “high P/E ratio” logic on its head…

They’ll often look cheapest (with a low P/E ratio) at the worst possible time to buy. That’s usually right before earnings collapse.

And the opposite is also true…

Cyclical stocks often look most expensive (with a high P/E ratio) at the best time to buy. That’s when earnings have hit bottom and are about to rebound.

True, the S&P 500’s valuation of more than 30 times trailing 12-month earnings is high. But again, P/E ratios alone don’t determine investment success.

A stock with a low P/E ratio can still be a terrible investment if the business is deteriorating. Meanwhile, a high P/E ratio can be a powerful signal of a company’s growth prospects.

So when people worry about the market’s high P/E ratio, remember that the number itself doesn’t tell the whole story.

In investing, what really matters is finding quality businesses with strong fundamentals and growth potential.

Good investing,

Joe Austin

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Source: Daily Wealth