With the market correcting, Bears are taking absolute delight in castigating high-tech investors, especially those buying stocks with high PE ratios. Even Glassman, a usually intelligent business columnist for the Washington Post, last Sunday was questioning the wisdom of investing in favorite-of-the-day high-tech stocks, or even expensive thoroughbreds like Coca-Cola. The other day an article described how the correction has been forming over the last couple of months, and therefore was no surprise to the wary.
All this "I told you so", after-the-fact quarter-backing is nonsense. Since all the market gurus are now flooding the news media with phony reasons for running scared, I feel compelled to present the other side. What is the real story on the meaning of trailing PE ratios, and how do they relate to stock valuation?
The market does not buy trailing PE’s. The market buys the present value of current and future free cash flow, discounted by the time-value of money. Anything else can, and therefore will, be arbitraged to yield a profit. The act of arbitraging adjusts the price toward the theoretically correct, so-called intrinsic, value of the stock. I assure you that if a company’s future earnings were cast in bonze and laid out for all to see, the market would price the company just like it prices US Treasuries, resulting in a net yield at market rates. The difference between stocks and US Treasuries isn’t that equities are priced differently than bonds, but that the future return from equities is much less clear than the return from bonds. Nevertheless, it is still the market’s job to figure it out and price it accordingly.
The theory often breaks down when attempting to calculate present value of equities. The reason is that what happens in the far-out years dominates the present value calculation. While this may be acceptable to academics, it totally is impractical to the real-world investor. One particularly pernicious characteristic of discounting a future stream of cash is that sustainable growth rates greater than the market rate correspond to an infinite intrinsic value. In the real world, of course, companies cannot grow forever at greater than the market rates, but that theoretical boundary is not of much practical significance when trying to price a $50 million dollar company.
As a practical alternative, market-based measures, incorporating near- and mid-term expectations about company performance, are necessary to approximate intrinsic value. Benjamin Graham (Buffet’s mentor) developed a model decades ago that assumes intrinsic value is essentially proportional to earnings times the sustainable growth rate, G, expected for the company. With this approximation, the PE ratio should be about the same as G (with adjustments for the current time-value of money). The problem is, when applied to trailing earnings, this model is egregiously wrong. To prove this, consider WIND as a case in point. Last fiscal year, WIND returned a 100% increase in earnings, and continued the performance in this fiscal year’s first quarter. If we believe that sustainable earnings growth will be 45%, as reported by one analyst following the company, the model would say the price of the stock should be about $.40*45 = $18 per share.
Now look ahead one year, and what do you see. Trailing earnings will be at least $.60 per share, and the outlook (i.e. estimated sustainable growth) should still be at least 45%. Assuming interest rates do not change, next year the price should be about $.60*45 = $27 per share, a 50% year-on-year increase.
The market is not going to stand around and let anybody walk away with a low-risk 50% return. Since next year’s $.60 cents seems certain, the market would bid up the $18 to nearly $27/(1+market interest rate), which is about $25. Now look at the PE ratios. Next year it presumably will be 45; whereas this year it will quickly adjust to about 62. What happened to our rule that trailing PE ratios should be about the size of the sustainable growth rate? And if this year’s PE of 62 is acceptable, maybe next year should be 62 also. Of course then this year’s PE would immediately adjust through arbitrage to about 86, or a price about $34. There is no logical end to this thinking, meaning that the trailing PE ratio gives no clue about the intrinsic value of a stock.
Another way to throw cold water on the rule-of-thumb, that the trailing PE ratio should be about the size of sustainable growth, is to calculate the effects of growth. Suppose WIND earns 51 cents this fiscal year, and consistently increases earnings 45% for five years (justifying the sustainable growth estimate). Suppose further it settles somewhat after that but continues to grow earnings at 25% for another 10 years - which is an understatement for what we expect given its leading position in a major paradigm shift for computers. If the market understood and believed this story, then it would price the stock today at about $200. That would correspond to a trailing PE ratio today of 500. (This is actually what Warren Buffet does well. He buys companies that he knows have the franchise to grow consistently over the years. He then just patiently awaits the market’s convergence to an intrinsic value that is substantially greater than what he paid.)
It is now evident that a pricing model proportional to trailing earnings times the sustainable growth rate is irreparably flawed for growing companies. Its logical inconsistencies with market mechanics become evident when viewed from year to year. Despite the almost universal popularity of reporting and calling attention to the trailing PE ratios, many financial analysts know about this weakness. For this reason, they often price a stock using this or next year’s estimated earnings, and the rule-of-thumb or an historical PE for the sector. While this is a giant improvement over the use of trailing PE ratios, for franchises a longer look into the future is justified to determine intrinsic value of a stock. If you can find a company that will produce above average earnings for the foreseeable future, that company warrants a very high trailing PE ratio.
Allen, |
