MUST READ! Briefing.com: On Stock Prices - Record PE Ratios
28-May-02 01:14 ET
[BRIEFING.COM - Robert V. Green] If you have lost money in the past two years, you tend to think that prices of stocks are down. But the true price of a stock is not the dollar per share quote, it is the valuation metric. By that standard, prices of stocks have risen the past quarter to their highest historical level in the past fifty years.
The True Price Of A Stock - Not Per-Share Cost
In general, per-share stock prices are meaningless.
Only the overall "market capitalization" for the company is important.
There is no difference between a stock with one hundred million shares outstanding selling at $20 and one with ten million shares outstanding selling for $200. Both companies are worth exactly the same amount: $2 billion.
Market Multiples
More important than share price, in determining whether a stock is "expensive," is the valuation placed on the company's principal business metrics: sales and earnings. The two primary "multiples" are Price/Earnings and Price/Sales.
Price/Earnings ratios, or P/E, was the dominant driving valuation standard during the 1980's and early 1990's. (Prior to then, dividend yield was a significant driver of stock prices.) The PE ratio takes the price per share divided by the earnings per share of the company.
Price/Sales, or P/S, became a more important valuation standard for technology stocks in the later part of the 1990's. This ratio takes the price per share divided by the revenue per share. A more accurate way to view P/S is the market capitalization of the company divided by the revenue of the company.
Whether a stock is "expensive" or "cheap" is largely determined by the relationship of the P/E or P/S to other similar companies, or, in this discussion, to time periods in the past.
Valuation - Historical Standards for PE
The S&P 500 is probably the best known index for the entire market. Fortunately, the earnings data for the S&P 500 goes back a full fifty years.
From 1954 forward, the PE ratio on the S&P500 has ranged from about 7 to 35. This year, 2002, is a notable exception.
Prior to the beginning of 2002, the all-time high PE on S&P500 stocks was about 35, as shown in the table below.
Previous All Time High All Time Low Bear Market Low 1974 Pre-Crash 1987 Now
Value 34.7 6.7 7.3 22.3 43.90
Date June 1999 April 1980 December 1974 August 1987 May 2002
Here is a chart of the history of PEs, monthly, since 1954.
Conclusion
The chart tells it all: Stocks have never been more expensive than they are right now.
This is not a commonly talked about fact lately, as everyone prefers to think of stocks are cheap. After all, with the per-share dollar price off as much as 90% for so many stocks, stocks should be cheap by now, shouldn't they?
That line of thinking, however, is misleading, as the true measure of the price of a stock is the market multiple. From that perspective, stocks are expensive.
There are only a few possible conclusions from the S&P500 PE data:
Expectations for a strong earnings recovery in Q2 are high, which would bring the PE ratio back to more historical levels in the twenties.
There is excess buying demand for stocks than in the past.
Investors are willing to pay more for stocks in the current environment than they have in the past.
Selling pressure in the face of declining earnings is not strong enough to drive prices down dramatically.
The first explanation seems to correspond with general optimistic sentiment ("thing will get better from here"), but for a single quarter to be strong enough to double trailing twelve month earnings, thereby cutting PE ratios in half, seems very unrealistic.
The second explanation follows basic economic principles: more people chasing fewer stocks keeps prices higher. At the moment, we don't have data to support such a theory, however.
The third explanation is difficult to imagine. Pay more than the bubble era? Who would admit to doing that?
The last explanation seems to have the most credence, although we again admit to having no evidence to support it. This approach would have investors preferring to hold rather than sell, in the current environment. With bond rates low, cash rates even lower, what else is there to switch your stock investment to? In addition, 401(k) investors appear not to be moving from their 60% equity allocations, and the weekly inflow of cash keeps a strong buying pressure for stocks. Could inertia and auto-pilot investing be the driving forces to higher PE ratios?
No matter how it is explained, however, it is important to recognize that stocks, from a historical perspective of valuation, are more expensive now than they have ever been in the past fifty years.
Comments may be emailed to the author, Robert V. Green, at rvgreen@briefing.com |
