Susan, while the old standard that a stock should have a PE equal to its historical and expected future growth rate is broadly accepted, it is not necessarily true. I think that the rate of return of different asset classes has more to do with "fair valuation" of such asset classes. I say "fair valuation, since markets do go to extreme "overvaluation" as well as extreme "undervaluation" and are rarely at "fair valuation". In any event the return of a stock selling at a PE of 20 is exactly 5%. This is total return (the fact that some of these returns are distributed or not does not affect the returns, as will explain below). If a company pays some of these returns out in dividends, the holder of the stock actually get a smaller rate since he has to pay taxes on this. Similarly, most investors have to pay taxes on their bonds holdings interest paid. If you assume a tax rate of 36%, your real rate of return on a 5.5% bond is only 3.52%. For non dividend company (one that reinvest all its retained earnings in the business), the equal point should be a PE of 28.4 (1/.0352).
We hear a lot that the market is overpriced because the dividend rate of the S&P is much lower than the median standard of 3% or so. One thing we do not take into account is that corporate America is buying back its stock. This is actually the greatest "tax evasion" scheme in recent times (such tax loopholes when closed in the past have caused major dislocations in our markets, the closing of the real estate passive losses tax loophole is what brought us the S&L crisis), but it is reality. Take MRK, their indicated dividend rate is a miserable 1.38% ($1.8/share), but they have bought back some 8 billions worth of stock in the last 2 years. For the sake of argument, let say that they repurchased $4 Billion last year (or $3.33/share). To pay out the same amount net of taxes they would have had to pay out $5.2/share, or the actual payout would have been $7/share, or a rate of return of 5.38% vs 5.5% for a bond with a fixed rate of return (MRK business is still growing at a 17% to 20% clip). Thus even on that basis of dividends (and I mean total dividends), MRK is still fairly priced relative to alternative assets (bonds), at a PE of about 27 or so.
When you add to this fact the liquidity available to maintain the markets, I could see MRK stock going to slight overvaluation in the near term (I have 145 within the next 3 months) without creating an extreme bubble. If liquidity dries however, then run to the mountains. However, in the near future I do not see liquidity drying up for reasons I have elaborated on in prior posts.
Zeev |
