Zeev's Turnips Patch-No Politics (ZEEV)

[Train Guy]

On the Marc: Are P/Es too high?
30 Jun 2003

A question that seems so simple is really quite complex
Marc Gerstein Director of investment research MultexInvestor

Undoubtedly you've heard it said recently: Avoid jumping into stocks, because it's not possible for a "real" bull market to begin when price-to-earnings (P/E) ratios are as high as they are right now. I wish market analysis were that easy; if it were, I'd be so darn rich I'd own not only my favorite baseball team, but maybe the whole of Major League Baseball as well.

Sadly, it's not that simple. In last week's article, "The precedent trap," I showed what can happen to those who see too much simplicity in complex questions.

What do we mean by P/E, exactly?

The first problem we face in answering the question posed by my article's title is to figure out where P/Es are right now. As of this writing, I come up with the following for the S&P 500.

- The P/E based on trailing-12-months (TTM) GAAP EPS is 26.03
- The P/E based on the consensus estimate of EPS for each company's current fiscal year is 21.77
- The P/E based on the consensus estimate of EPS for the next fiscal year for each company is 18.82

But this only scratches the surface of the possible ways of evaluating the situation, as you can see by noting the following.

- The above P/Es are based on the market-cap-weighted averages of the S&P 500 companies. If I were to compute simple averages, the results would be different.
- The time periods over which EPS are measured are not uniform; I pulled the information from our professional screening tool, which references the current and next fiscal years for each company. But not every fiscal year ends at the same time. Had I ignored fiscal periods and gone into a different database that allows me to recompute each company's earnings based on common calendar periods, I'd get a different set of answers.
- If I were to use operating results for the TTM period (that is, if I ignored non-recurring items on the income statements), I'd get different TTM P/Es.
- Many companies are losing money. These "NM" (Not Meaningful) P/Es are omitted from the calculation. If I simply summed up all the individual EPS figures for the S&P 500, whether they were positive or negative, the overall result would produce a very different TTM P/E: 76.8.

There are many other ways we could parse the information as well, but I think you get the idea. On the whole, if you read an article that discusses P/Es but doesn't tell you how the P/Es were calculated, you are probably wasting your time.

P/Es, like earnings, are volatile

For now, let's go back to the first three ratios I calculated. Notice the progression from 26.03 (based on TTM EPS) to 21.77 (based on estimated EPS for the current year) to 18.82 (based on estimated EPS for next year). Someone who is bearish will gravitate toward the 26.03 figure. A bull will call your attention to the 18.82 figure. And judging by the tone of today's rhetoric, chances are that the bear will belittle the bull for relying on analyst pipedreams instead of objectively verifiable fact.

It's so easy to be a macho bear three years into a bear market! Where were they in 1999, when we really needed them? Actually, though, the macho answer is the one that's least valid. In "Investment Valuation" (Wiley 1996), Aswath Damodaran articulates an important principle we all need to understand, especially at times like these, when the economy has been lackluster.

[T]he volatility of earnings can cause the PE ratio to change dramatically from period to period. For cyclical firms, earnings will follow the economy, whereas the prices reflect expectations about the future. Thus it is not uncommon for the PE ratio of a cyclical firm to peak at the depths of a recession and bottom out at the peak of an economic boom.

Applying the reasoning of the macho bears, if P/Es peak at the depths of recession, we should not buy stocks at the depths of recession.

Think about this for a minute.

How many people do you know who got burned buying stocks during the depths of recessions? The investors I know who got burned bought at the peak of the boom, not at the depths of recession. What's more, those who bought at the last peak, in 1999-2000, weren't doing so at low P/Es, as Damodaran suggests they should have been doing. As I recall, P/Es were frighteningly high during the last peak. So investors took a double wallop: Bottom lines plummeted at the same time P/Es were crashing.

Are recent warnings a case of "garbage in, garbage out"?

Still, writers out there are saying that P/Es were lower at the start of bull markets past. What are they referring to? Is it something other than what Damodaran wrote about?

One problem I have is that the macho bears I hear or read about don't explain how they are computing P/Es. Nor, in fact, do they identify the precise periods they are measuring. I hope they aren't comparing forward-looking P/Es from the past with TTM P/Es from the present. And if they are, in fact, using apples-to-apples computation methods, I hope the periods they are measuring are at the same points in their respective cycles. I'd hate to think TTM P/Es based on 1992 earnings are being compared with TTM P/Es based on 2002 results. Is anything like that happening? I have no idea.

In today's market, the lessons of precedent are limited

Now, let's assume there are some authorities out there whose comparisons are proper in terms of calculation method and comparability of measuring period. I'm willing to make this assumption, because I'd still expect P/Es to be higher than they were at the start of past bull markets.

P/E ratios are very strongly influenced by growth expectations and interest rates. This fits what we learn from Damodaran. At peak periods, it's as if we're looking down toward the bottom of a cliff: Growth prospects are poor, probably negative, so P/Es should be low. In recessions, it's as if we're looking up from the bottom of a pit. Growth prospects are powerful, so P/Es should be high.

But there's more to growth than cyclical turns. We now know that the 1990s witnessed tremendous gains in earnings, as productivity soared, new technologies emerged, and new industries grew from infancy to ubiquity.

As I recall, personal computing was out there in 1991, but I don't remember the investment community foreseeing the full extent of the tech boom that followed. I'm not even sure I knew what the Internet was in 1991. I was online, but that was for DOS-based dedicated online services that I accessed with a 14.4 Kbps baud modem. This is just one anecdotal example. I don't mean to imply we expected no growth back then, but what we envisioned surely turned out to be far short of what we actually experienced. However, P/Es at the time were based on what we expected back in 1991, not the stronger growth we actually wound up enjoying.

Today, our expectations are more aggressive than they were in 1991. We know about the Internet, wireless technology, and so forth. Arguably, this stuff is passé now. But beyond that, we are attuned to the ways technology can impact long-term earnings growth. So we have higher expectations.

We might be wrong; after all, that was the case in 1991. But don't wait for P/Es to compress. If investors expect strong growth, P/Es will reflect that. I suggest spending less time comparing today's P/Es to past P/Es and more time thinking about whether you agree with widely held growth expectations. That's the make-or-break issue.

As to interest rates, the other major influence on P/Es, they are at historic low levels. That alone has to push P/Es higher than they were in recent downturns. In other words, if we expected 10 percent annual growth in 1991 and we expect 10 percent annual growth now, then P/Es now must be higher than P/Es in 1991 simply because of interest rates.

I'd be amazed if interest rates weren't significantly higher five years hence. That would put downward pressure on P/Es. We'd also be five years closer to peak earnings than we are today. That, too, should put downward pressure on P/Es. But that does not necessarily mean stock prices will be lower. Maybe they will be. Maybe they won't be. It depends on earnings growth.

If earnings grow, so, too will stock prices. If earnings slide, so to will stock prices.

- EPS of $4.00 and a P/E of 8 equates to a stock price of $32.
- EPS of $1.00 and a P/E of 20 equates to a stock price of $20.
- EPS of $0.50 and a P/E of 30 equates to a stock price of $15.

The market is not a one-trick pony. P/Es are important, but you are not helped by mindless recitations of precedent that fail to put these important metrics into a proper context. Given today's growth expectations and interest rates, nobody should hold his breath waiting for P/Es to fall to levels seen in the past. Focus, instead, on the issue that really matters: growth.

You may wind up concluding that even long-term earnings prospects aren't all that great and that stock prices are ripe for correction. Such a view would be especially reasonable given the spring rally, which may have incorporated more optimism than some companies can deliver upon.

But it's very important to distinguish between bearishness (or caution that is based on an assessment of growth prospects) and a stance that hinges on rigid adherence to P/E precedent. If you base your view on growth expectations, you'll continually stay aware of unfolding events and be willing to buy stocks if and when you have reason to believe that growth prospects become favorable. On the other hand, if you focus on P/E precedent, you probably will not move into stocks when bona-fide growth arrives and will instead wind up falling into the precedent trap and doing what Joe Granville's followers have been doing since 1982—waiting indefinitely for the market to come to its senses and do what you think it must do before you'll get in.

http://dai.multexinvestor.com/Article.aspx?docid=1448&target=economicview&nd=0630_DAI_AAC_L0...