Monday, August 30, 2010

Sinking Importance of the PE Ratio or so They Say

Interesting article from the Wall Street Journal that summarizes our frustration with the current market. Rather though being the death of the Price to Earnings Ratio (or PE) the markets will likely look back in 5 to 10 years and wish they'd paid attention. Corporate profits are at record levels and companies with low PEs are likely to outperform in the next decade. Especially when considering the PEG ratio or the growth component of the earnings.

Companies with growth rates higher then the PE will undoubtedly outperform. In the markets eyes though, the question remains on how to determine which companies will outperform. Some of the winners like Salesforce.com (CRM) have already soared to outlandish PEs because market has deemed their growth as transformational. The market thinks CRM will grow rapidly even in a weak economy so they've priced in the growth. Other stocks are marred with low PEs and reasonable growth estimates that have a low risk of not exceeding a 6-8 PE.

Regardless, typically financial measurements and styles fall out of grace at the exact moment they should be utilized even more. Also, the most annoying example of the PE being too high doesn't take it into context correctly. The PE only measures the value of a stock but it doesn't measure its value compared to other asset classes. In the late 70s and early 80s, interest rates were much higher then the historically low rates of now. Would you rather have a money market fund making 15% a year or take the risk of owning a stock? Most likely the money market fund but what if stocks got sufficiently cheap. Say 6.5x earnings! Sure wouldn't have been paying 15x or an earnings yield below 7 when risk free money was paying much more.

Oddly we've got just the opposite scenario where numerous stocks yield in the 12-15% range and money market funds pay next to nothing. Can't convince anybody of the 'cheapness' of stocks though due to the market uncertainty. Ironically though that's the time to buy. Not when the market seems it will grow for ever and PEs are in the 20s like in 2000.

  • The stock market's average price/earnings ratio, meanwhile, is in free fall, having plunged about 36% during the past year, the largest 12-month decline since 2003. It now stands at about 14.9, compared with 23.1 last September, based on trailing 12-month earnings results. Based on profit expectations over the next 12 months, the P/E ratio has fallen to 12.2 from about 14.5 in May.
  • P/E ratios fell sharply during the Depression of the 1930s and again after World War II, bottoming at 5.90 in 1949. They plunged again during the 1970s, touching 6.97 in 1974 and 6.68 in 1980. During those periods, global events sometimes took precedence over company-specific valuation considerations in the minds of investors.

  • Equally troublesome, analysts' forecasts are becoming scattered. In May, the range between the highest and lowest analyst forecasts of S&P 500 earnings per share in 2011 was $12. Morgan Stanley predicted $85 per share, while UBS predicted $97 per share. Now, the spread is $15. Barclays said $80 per share; Deutsche Bank predicts $95.
  • But today's economic uncertainty argues against that scenario. Consider that while P/E ratios dropped during the inflationary 1970s, they also fell during the deflationary 1930s. The one common thread tying those two eras of falling P/E ratios: unpredictable economic performance.

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