The P/E's Important, but It Isn't Everything
By James K. Glassman
Sunday, March 10, 2002; Page H01
washingtonpost.com
The market has risen smartly in recent weeks, but the average stock is still down by more than one-fifth from its high of two years ago. Does that mean shares are still cheap? On the contrary, say analysts like James Grant. They're dangerously expensive.
In a recent op-ed piece in the New York Times, Grant pointed to research by the Leuthold Group of Minneapolis that shows that the market "would have to fall by 41 percent to reach the median valuation prevailing since 1957." In other words, for stocks to get back to reasonable levels (at least according to history), the Dow Jones industrial average would have to drop to about 6200. The Dow closed Friday at 10,572. It's a long way down.
Let me quickly say that I disagree with Grant and the other pessimists -- and I'll tell you why a bit later. But they offer a powerful message. You need to hear them out.
Their argument revolves around the word "valuation." All by itself, the price of a share of stock is meaningless. What counts is its relationship to something else -- such as the profits (or earnings) of the company that issued it, or the assets on the firm's balance sheet, or the dividends it pays. The most popular measure of such a relationship is the price-to-earnings, or P/E, ratio. Calculating a P/E is the main method of determining a company's valuation. |
