S&P 500 Rule of 20 Calculator

Written by:
PK

On this page is an S&P 500 Rule of 20 Calculator. It adds the S&P 500 Price to Earnings Ratio (PE Ratio) to the year-over-year change in inflation (as measured by CPI-U) to come up with a dimensionless value to compare to 20. The tool shows the historical Rule of 20 valuation for the S&P 500 back to 1872, plus the current, max, median, and average Rule of 20.

What is the Rule of 20?

The Rule of 20 is a dimensionless number that adds the current 12-month trailing Price to Earnings Ratio to the annual change in an index of the annual consumer inflation rate. A reading below 20, while a market is trending lower, means that we could be near a bottom.

In the United States (and in this tool), the most common index used is the broad-based S&P 500, and CPI-U is used as a proxy for inflation.

The Rule of 20 is purportedly a rule from Peter Lynch – although I can't source the quote at the moment, Lynch supposedly mentioned 20 minus the inflation rate as a fair value for a company. In chapter 39 of Graham and Dodd's seminal Security Analysis, they mention:

"We would suggest that about 20 times average earnings is as high a price as can be paid in an investment purchase of a common stock."

... with no mention of inflation. Lynch's formulation attempts to factor the 'gravity' of interest rates into the fair value of a stock. And, as you can see, the measure has fluctuated quite a bit. However, it has returned to roughly the 20 level repeatedly.

Rule of 20 Formula

The rule of 20 formula is:

rule\ of\ 20=\frac{price}{earnings}+YoY\ inflation

Where:

• Price - the current trading price of a total market index
• Earnings - the earnings of a share of a company over 12 months
• YoY inflation - the percentage change in a country linked to the index. This is expressed as a whole number, or percentage multiplied by 100

Limitations on the Rule of 20

Limitations on the Rule of 20 tend to align with those on other Price to Earnings metrics – although adding an interest rate proxy to the mix with inflation does improve the measure slightly. As noted in the S&P 500 Price to Earnings ratio tool, earnings aren't necessarily the best measure of current company performance.

Additionally, recessions can temporarily depress earnings, sending the PE ratio up, although an index's price might already be declining. 2008-2009 is an excellent example of this effect, as aggregate earnings were barely positive over a 12-month period, sending the PE ratio of the S&P 500 well over 100 as the market bottomed in March of 2009.

Other Measures of Market Valuation

Here are some other automatically updating tools which track the valuation of major total market indices:

PK

PK started DQYDJ in 2009 to research and discuss finance and investing and help answer financial questions. He's expanded DQYDJ to build visualizations, calculators, and interactive tools.

PK lives in New Hampshire with his wife, kids, and dog.