Share values
Virtually useless as a guide to 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.
In effect, we are using prices to determine values. This is a fundamental flaw.
For example
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.
Three points
- It’s a mistake to let the market tell us what a proper price earnings ratio should be
- Price earnings ratios are simply a very rough guide to fair value even at the best of times
- Earnings and price earnings ratios don’t mean what they used to. See my post: Investment in intangibles has wreaked havoc on the meaning of multiples
Let’s go back in time and reflect on the price earnings ratios common in various periods of stock market history.
Before the Great Financial Crisis (GFC)
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. But this was in a run up to a serious stock market collapse!
In 2006 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.
During the GFC
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 off and depressed earnings. In fact, there were outstanding values in the stock market at that time! It was a good time to be a buyer.
A little history
The evidence mentioned in the preceding paragraphs 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, let’s look back further in time. We need to understand not only the economic backdrop but also the level of animal spirits.
Perspective from the 1990s
Older investors will remember the 1990s. It is amazing to think that many investors will know little of the dot com stock market bubble.
From about 1992, the stock market was on a tremendous bull run. Technology stocks were driving the market but many other sectors were performing well.
Alan Greenspan, the chairman of the Federal Reserve spoke to the American Enterprise Institute at its December 5, 1996 dinner and, in part said (including a reference to price earnings ratios):
“Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by Price/Earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions, as they have in Japan over the past decade? …” (Greenspan, The Age of Turbulence 2007) p177 (emphasis added)
Writing from the perspective of 1998, not long after Alan Greenspan’s comments about ‘irrational exuberance’, Jeremy Siegel lists his eight key points for structuring a portfolio for long term growth. His point six is headed: ‘Large “growth” stocks perform as well as large “value” stocks, and some are worth 30 or more times earnings.’ (Siegel, Stocks for the Long Run – The Definitive Guide to Financial Market Returns and Long-Term Investment Strategies. 1998) p286 (emphasis added)
Could sustained low inflation and sustained low interest rates have justified price earnings ratios of 30 or more? From the perspective of the late 2010s, ten years after this was written, paying a price earnings multiple of 30 or more for a large growth stock seemed absurd. From the perspective of 2024 with the magnificent 7, it doesn’t seem so absurd.
I mention this not to criticize Professor Siegel. We are conditioned to believe that what Mr. Market is prepared to pay for a stock, i.e. market price, is the true worth of a stock. In behavioral psychology terms, the current S&P 500 price earnings ratio produces an ‘anchoring’ effect in the minds of investors. But we must remember that essentially the expression ‘market value’ is an oxymoron.
Perspective from the 1980s
Let’s reflect for a moment about price earnings ratios in the 1980s.
Every opinion expressed about price earnings ratios must be understood in the context of the investment climate at the time the view is expressed.
Take Peter Lynch’s comment written in the late 1980s: “You’ll also find that the Price/Earnings levels tend to be lowest for the slow growers and highest for the fast growers, with the cyclicals vacillating in between. That’s as it should be…. An average Price/Earnings for a utility (7 to 9 these days) will be lower than the average Price/Earnings for a stalwart (10 to 14 these days), and that in turn will be lower than the average Price/Earnings of a fast grower (14-20). Some bargain hunters believe in buying any and all stocks with low Price/Earnings, but that strategy makes no sense to me. We shouldn’t compare apples to oranges. What’s a bargain Price/Earnings for a Dow Chemical isn’t necessarily the same as a bargain Price/Earnings for a Wal-Mart.” (Lynch, One Up on Wall Street. 1989,1990) p164 (emphasis added)
Lynch wrote this in 1989.
Perspective from the 1950s, 1960s and 1970s
Benjamin Graham notes that between 1949 and 1969 the price of the DJIA had advanced by more than fivefold while its earnings and dividends had about doubled. (Graham, The Intelligent Investor, fourth revised edition. 1973) p 9
This necessarily meant that there was a substantial expansion in price earnings ratios. Price earnings ratios began the 1950s in single digits. By 1969, the price earnings ratios of many of the Nifty Fifty stocks was well over 50.
Graham was not to know at the time that edition of The Intelligent Investor was published but, by the end of 1974, price earnings ratios had collapsed and many solid companies could be bought in the mid 1970’s at price earnings ratios of ten or even less.
Peter Lynch writes: “But interest rates aside, the incredible optimism that develops in bull markets can drive Price/Earnings ratios to ridiculous levels, as it did in the cases of EDS, Avon, and Polaroid. In that period [referring to the late 1960s], the fast growers commanded Price/Earnings ratios that belonged somewhere in Wonderland, the slow growers were commanding Price/Earnings ratios normally reserved for fast growers, and the Price/Earnings of the market itself hit a peak of 20 in 1971.” (Lynch, 1989,1990) p168 (emphasis added)
In general
The reality is that price earnings ratios are virtually useless as a guide to fair value.
Conclusion
My first point was that it’s a mistake to let the market tell us what a proper price earnings ratio should be.
Second, what we can draw from this history is that there seem to be ups and downs in price earnings ratios that can last over several business cycles. We can suppose that interest rates and inflation contribute to these cycles but do not control them nor are they necessarily the major contributing factor.
Price earnings ratios can vary widely from less than ten times earning to more than fifty times, and during the different eras Mr. Market can accept almost any number as appropriate.
Investors simply don’t know whether the glass is half full, half empty or somewhere in between and if so, what direction price earnings ratios are headed in.
Price earnings ratios are simple a very rough guide to fair value even at the best of times. They are also a very dangerous guide to fair value.
Finally, and crucially, with the rise of company investment in intangibles of lasting value, there has been a secular change in the meaning of reported earnings which has wreaked havoc on the meaning of price earnings ratios.
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