Traders, analysts, investors, and commentators through around relative valuation metrics like the Price/Earnings ratio without taking some time to understand and analyze the fundamental factors driving the ratio. Here, I explain why that is a self-defeating approach to investment screening and investing, and how, using a fundamental P/E model, investors can focus on the drivers of the ratio (cash flows, cost of equity capital, and long-term growth) between firms, across industries, and over time, so comparisons/analysis based on P/E has much-needed context.
I use the fundamental P/E model to analyze the S&P 500, from which I calculate an implied long-term growth rate of a little over 4.5%, in contrast to analysts' estimates which are much higher than that (around 8%). The take-away is that by understanding the drivers of P/E, you can better determine if an index or stock really is cheap/fairly-valued/expensive, based on whether each of those drivers makes sense, as opposed to looking at the reduced ratio of price to earnings, which is very obscured and entirely too high-level for useful comparison.
This should at the very least, make investors think harder about what they're really doing when using P/E ratios, which in turn, should lead to better investment selection/performance.