I am constantly amused at the talking heads on CNBC and Fox Business as well as analysts’ articles in a number of publications (both paper and electronic) that harp on the notion that the stock market is cheap — or at least not expensive — based on the notion of the price-to-earnings ratio. How naïve is that?!
Price-to-earnings ratios (or P/E) are a fractional measure of a company’s earnings per share to its stock price. So quite literally, it is the ratio of the current stock price to the current or most recent earnings per share. A stock with a current price of $20 per share and earnings of $2.00 per share would have a current price-to-earnings ratio of $20 divided by $2 or 10 times earnings.
Individual stocks have price-to-earnings ratios as long as they have positive earnings. Stock-market averages also have average price-to-earnings ratios, and analysts talk about the average price to earnings of the Standard & Poor’s 500 Stock Average. So we have comparative benchmarks against which we can say that a stock is more or less expensive than another stock or the stock-market average. So stocks can be expensive or inexpensive based on absolute price as well as relative value measured by the price-to-earnings ratio. We now have another tool in our evaluation tool box to get a handle on relative valuations.
Historically, price-to-earnings valuations have ranged far and wide. It is rather pointless to base anything on the average price-to-earnings ratio. To use a similar example, the average depth of the Susquehanna River tells us very little except that, on average, nobody should be able to drown given that the Susquehanna’s average depth is six inches. Of course, that doesn’t address the fact that the river has really deep holes and shallow places and you can drown in those deep holes.
Likewise, the average price-to-earnings ratio is rather pointless. It can be high by historic ranges or low by historic ranges or somewhere in the middle. None of this valuation conversation leads to the real beef, as they say.
In other words, should you buy, sell or hold based on a particular price-to-earnings ratio? The answer is that no one knows. As Investors Business Daily has noted, price-to-earnings ratios are not predictive to future stock price performance.
Now, the news outlets have many hours of financial conversation to fill, and some of that time is devoted to things that just don’t matter to those who are looking for great investment ideas. In my opinion, most of the chatter on the networks is rather useless in determining good investment ideas. Still, they are a good source of news and so I listen.
The real value of price-to-earnings ratios is to tell you when an extreme in pricing has been reached. Twice in my career, spanning 46 years, I have noticed that stocks were either very expensive or very cheap by historical standards with regard to the P/E ratio. I recall vividly the edition of Value Line from late December 1974, where the service indicated the average price-to-earnings ratio for the 1,700 stocks in the Value Line Geometric Average of stock prices. At that point in time, the average price-to-earnings ratio was 4.8 times earnings.
Then, at the most recent turn of the century, during the high-tech boom, many companies had high stock prices and no earnings. Any price divided by zero gives a P/E ratio of infinity, which is a very large number. I recall the P/E ratio was more than 40 times earnings for the S&P 500 Stock Average, or very expensive, relatively speaking.
All other things being equal, there was one buy point and one sell point if you were buying the market averages.
The other use of the historic range of price-to-earnings ratios is to see what might happen to stock prices if price-to-earnings ratios ran to an extreme. In this case, given the current earnings, the price-to-earnings ratio of the Standard & Poor’s 500 Stock Average declined from its current level (13.98 times earnings) to 4.8, then the average would be around 386, down from the current level of 1126 currently. The Dow Jones Industrials, if that is your preferred market average, would be trading around 3711 or so, back where it was trading in the early 1990s. So from my vantage point, the risk in the markets is in returning to the extremely low market valuation.
I recall individual stock prices were trading at two and three times earnings in the middle ’70s, when we were buffeted by rising oil prices, an accommodative Federal Reserve and awful fiscal policies at the federal level that resulted in high taxes, high inflation and high unemployment and a sick stock-and-bond market all at the same time. Now I notice that Ford, General Motors, Hewlett Packard and other notable large companies are now selling at five times earnings. Could we be getting to the point where stocks, at least some stocks, are relatively cheap?
Time will tell.
