Price earnings ratios
The search for fair value
What is the correct price earnings ratio for a particular company to indicate fair value? Is it the average of its price earnings ratios in the last few years? Is it the average of the current price earnings ratios of its peers? Is it the current price earnings ratio of stocks with a similar growth profile? Is it the current price earnings ratio of an index like the S&P 500 or of some sub index like the banking index if we are valuing a bank? Is it the current CAPE ratio?
They all have a serious shortcoming. The problem with these approaches is that these comparative ratios are generated by market prices and those prices may be way over fair value or way under. We have no way of knowing. See my post: The conventional view of market efficiency is badly mistaken
In effect, in using the market to give us price earnings ratios, we are using prices to determine values. This is a fundamental flaw. Benjamin Graham warns us that the stock market is a voting machine not a weighing machine. If a stock has been trading at a price earnings ratio of 17 in the last few years one might think that a prediction of earnings for the coming year that produces a price earnings ratio of 15 suggests the company can be bought at a fair price today or even at an advantageous price. But, that is based on the assumption that the last few years’ average of 17 indicates fair value. Using this approach one has never turned one’s mind to the question of fair value.
Using that thinking, most investors will accept that a price earnings ratio of 17 produces an estimate of fair value. But, they are simply accepting that the stock market has been efficient in determining fair value.
In 1999, to take the case of a market showing irrational exuberance, many investors believed current price earnings ratios were a good guide to fair values. The S&P 500 price earnings ratio in that period was about 30 times. The same would have been true in all excessively priced markets over the years. In the recession that followed the dot com boom the S&P 500 price earnings ratio went up into the 40s; yes, 40 times earnings! That was because of the recession in earnings.
The flip side is that in the summer of 2006 the S&P 500 price earnings ratio was at about 17 times, low in relation to where it had been the previous five years and very much a reflection of strong earnings in a strong business environment. At 17 times earnings, the market at that time was priced well over fair value. This was in a run up to a serious stock market collapse.
The price to earnings ratio of the S&P 500 was telling investors nothing; nothing about the stock market as a whole and nothing about individual shares.
In April 2009, in the depths of despair during the financial crisis, the S&P 500 price earnings ratio shot up to over 100 times earnings, a reflection of massive write offs and depressed earnings. In fact, there were outstanding values in the stock market at that time.
One might even argue that, in general, price earnings ratios are virtually useless as a guide to fair value.
The evidence mentioned in the preceding paragraph is of such recent history that most investors will recall the events. To make the point that there is nothing new in the stock market, we can look back further in time. We need to understand not only the economic backdrop but also the level of animal spirits. To do this, see the Sections referred to at the end of this post.
There is no absolute price earnings ratio that reflects fair value either for an individual stock or for the stock market as a whole.
Price earnings ratios may expand and contract over periods in the order of decades. The best time for an investor is when the price earnings ratios of either individual stocks or of the market as a whole are expanding. These periods are a reflection of changes in long term bond yields and discount rates, changes in inflation, changes in the investment community’s expectations for profits in years to come and changes in animal spirits.
Increasing intangibles investments that create assets of lasting value that whose cost is expensed against current earnings are changing the nature of reported earnings. For more on that issue see: Is the price earnings ratio (P/E) obsolete?
Better stock market regulation, better reporting standards and better market liquidity may be causing a secular reduction in the Equity Risk Premium.
Both of these secular factors may be affecting the appropriate level of price earnings ratios. What was appropriate in one era may not be appropriate in another.
For readers wanting to dig deeper into this subject, take a look at Chapter 39. Use of ratios to value shares
In particular, Chapter 39 contains the following relevant Sections:
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