**Slightly OT** P-E's AREN'T AS LOONY AS THEY LOOK. 5/7/98 BusinessWeek [Interesting analysis. Comments appreciated. djane]
Key excerpt: "EXPONENTIAL. Edward M. Kerschner, PaineWebber Inc.'s chief investment strategist, argues that many investors have underestimated the power of the bull market because they haven't properly gauged the impact of lower interest rates and lower inflation. Kerschner says the fair value of equities increases at an accelerating rate as inflation falls. Consider a company with a 15% earnings-growth rate when inflation is 5%. Kerschner says its p-e should be about 15. Cut the inflation rate to 3%, and the p-e for that 15% earnings growth rate doubles to 30. Cut inflation another point, to 2%, and the fair p-e jumps to more than 60. Says Kerschner: ''Just as with a bond, when you lower the rate at which you discount the earnings, the value increases exponentially.''
P-e ratios are loftier than ever. But
don't bail out just yet
Worried about the sky-high stock market? For years, investors who sweated
about that could look to the market's price-earnings ratio and take at least some
comfort. Through last year, even as p-e ratios climbed, they were still below the
old high of 23 hit in the early 1990s. But in 1998, prices accelerated far faster
than earnings. Now, the market's p-e, 26.7 for the Standard & Poor's 500-stock
index, sits at a level that, to many, defies logic.
But don't head for the hills just yet. Those p-e's didn't climb to Himalayan heights
on mindless speculation. Stock-price multiples are high for good reason: Over the
past three years, reported earnings have grown by more than 50%; long-term
interest rates have fallen from nearly 8% to less than 6%, even as gross domestic
product expanded; and inflation has dropped from 3.3% to 1.4%.
''Sure, p-e's look high by historical standards,'' says Richard Bernstein, chief
quantitative strategist at Merrill Lynch & Co. ''But how many times in the
market's history have you had a combination of GDP growth in excess of 4% and
inflation under 1.5%?''
HALCYON DAYS. Not many. The years 1961-64 fit the bill, and during that
period, the average p-e for the S&P 500 was 19. But in the early 1960s,
economically sensitive manufacturing and natural resource companies loomed
large in the market. Today's market is dominated by technology,
consumer-product, and service companies with less dependence on the economic
cycle and more predictable earnings. In addition, the economy--now in its eighth
year of expansion--is proving to be far less volatile itself.
Given these almost ideal economic conditions, what is the appropriate p-e for the
stock market? That's one of the thorniest questions in investing. Market watchers
don't even agree on what number should be plugged into the p-e's denominator.
Most of the time, the oft quoted p-e's are based on the past 12 months' earnings.
That's a firm number that investors can find in the stock tables every day. But A.
Marshall Acuff Jr., equity strategist at Salomon Smith Barney, says it's useless.
''Investors look ahead, not back,'' says Acuff. ''Why use a historical number?''
Factoring in projected earnings, the S&P looks a bit more attractive: a p-e of
21.7, according to First Call Corp. But p-e's based on projected earnings are
usually lower than those based on trailing earnings, because analysts usually
predict profits will go up. The forward p-e is up from 17.1 a year ago, a 27%
move, but that's still less than 39% gain in stock prices. How does a 21.7 p-e
based on forecast earnings compare with the early 1960s and other periods of
high stock valuation? ''We just don't know,'' says Stanley Levine, director of
quantitative research at First Call. ''Wall Street didn't even start collecting
earnings estimates until the early 1970s.''
Still, any way you slice it, a p-e of 22 on forward earnings is a big number. And
it's most troubling for market veterans who struggle to grasp the idea that the
economy is in a new era of high market valuation. ''I have over 40 years of
investing experience, and it has been a handicap right now,'' says Robert H.
Stovall of Stovall/Twenty-First Advisers. ''I looked at p-e's and thought they
were high, but 32-year-old managers don't have that problem. They keep on
buying, and so far, they've been right.''
Stovall thinks high p-e's can be justified for many of the brand-name stocks that
have high-quality products and global distribution--such as Coca-Cola, Gillette,
and Microsoft--in an era of low interest rates and slow global economic growth.
He continues to hold such stocks but is putting new money to work in less
glamorous companies such as Chiquita Brands International Inc. and Midway
Airlines Corp.
EXPONENTIAL. Edward M. Kerschner, PaineWebber Inc.'s chief investment
strategist, argues that many investors have underestimated the power of the bull
market because they haven't properly gauged the impact of lower interest rates
and lower inflation. Kerschner says the fair value of equities increases at an
accelerating rate as inflation falls. Consider a company with a 15%
earnings-growth rate when inflation is 5%. Kerschner says its p-e should be
about 15. Cut the inflation rate to 3%, and the p-e for that 15% earnings growth
rate doubles to 30. Cut inflation another point, to 2%, and the fair p-e jumps to
more than 60. Says Kerschner: ''Just as with a bond, when you lower the rate at
which you discount the earnings, the value increases exponentially.''
Another market veteran, Kenneth Safian of Safian Investment Research, doesn't
think the S&P gives a good picture of the market. Instead, Safian uses an average
of 30 large growth stocks and adjusts p-e's for debt. His reading: The p-e is now
39, compared with 35-36 at other market peaks. Still, he says, interest rates are
low enough to allow p-e to notch up to the low 40s before the market is
dangerously overvalued.
There's some evidence, too, that the lightning-like runup of large-cap growth
stocks is distorting p-e's for the market as a whole and that the average investor's
portfolio has a more reasonable multiple. Martin M. Hertzberg, director of
research at DAIS Group, says if you calculate the p-e's of the S&P 500
companies equally instead of weighting them by the market value of the
companies, the p-e ratio is more modest--just 21.6, nearly 19% lower than the
current 26.7. ''The General Electrics and Microsofts are drowning everything
else,'' says Hertzberg. That suggests that while the S&P 500 has a high valuation,
most portfolios, which are equal-weighted rather than capitalization-weighted, are
more reasonably priced.
SQUASHED THUMBS. In considering the p-e question, the biggest trap that
investors can fall into is to rely on age-old rules of thumb that once worked but no
longer hold up. The dividend-yield rule--sell when the market yield drops below
3%--would have sidelined investors six years ago. The price-to-book-value
yardstick broke when the composition of the market changed from
asset-intensive manufacturing to asset-light but knowledge-intensive service and
marketing companies.
With this in mind, says Kerschner, it's a foolish rule to assume, just because the
long-term average p-e is 15, that p-e's must return to that average. ''My average
age is 23, but I'm never going to be 23 again,'' laughs Kerschner. ''That 'reversion
to the mean' thinking is a naive assumption. That was what investors did when
they didn't have any better way to analyze the market, so you'd assume the
average. With the computers and information we have today, you don't need to
do that.''
Merrill's Bernstein looks at the stock market's p-e through many models, and, he
admits, right now the answers are a mixed bag. ''The market's high,'' he says, ''but
not apocalyptically overpriced as it was in 1987.'' Back then, interest rates were
moving toward 10%. He says perhaps the most prophetic numbers come from
the audiences of investors he meets. ''I always ask how high they think inflation is,
and they usually come in at 2.5% to 3%,'' he adds. ''The real number is half of
that.''
That, says Bernstein, means inflationary expectations are far too high. ''A
resurgence of inflation could kill the p-e's, but where is it going to come from?'' he
asks. And a recession would also deflate the p-e's, yet that seems just as unlikely,
given the current economic scene. So p-e ratios, high as they are, still seem
justifiable--and who knows, they may even have room to expand.
By Jeffrey M. Laderman in New York
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CHART: P-E Ratios Are Way Up, But Interest Rates Are Down
and Inflation Has Dwindled
Updated May 7, 1998 by bwwebmaster
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