Dennis,
You make some very interesting points about P/E. I have a couple of followup thoughts. You write, for example:
1) Xerox sold for 100 X earnings in 1960 before it advanced 3300% in price.
Yes, but I assume (I wasn't there :-)) that it advanced 3300% in price because actual, higher earnings followed. Certainly, a company is worth a 100 P/E if its earnings are about to increase astronomically. In XRX's case, this was true. But a note of caution: plenty of companies have traded at a 100 P/E, only to have those stellar, anticipated earnings never materialize. In the long run, P/E does control. A stock with a 100 P/E can indeed turn out to be cheap if future earnings ramp up astronomically. Knowing the future, though, is hard :-).
Related to this is the question of how long a company can sustain rapid annual growth rates when it is already very large. For example, can CSCO sustain 35% annual revenue and profit growth (average) for the next 10 years? In that case, CSCO will be generating $48 billion in profit on $225 billion in annual revenues by 2009 (presumably excluding non-recurring charges relating to the acquisitions of Taiwan, France, and New Zealand :-)). Yet this kind of performance, and arguably more, is already built into the stock price. And maybe it will be so, and more. But I think it's risky to assume it will.
Another way to look at it: how much will CSCO's market cap appreciate, on average, over the next 10 years? 25%? Then CSCO will be a $1.5 trillion company in 2009. Can this happen? Anything can happen :-). Will it? We'll have to wait and see.
Of course, in the short run, stocks can move up (in today's climate, way up) for reasons entirely unrelated to earnings. AMZN can triple at the drop of a hat without any earnings at all. I sold AMD at 17 7/8, and COMS at 39 and change, a few months ago. Today, they're both trading below that on ... ahem ... negative earnings news. But both have traded well above those prices in the interim, so I'd be richer if I'd waited to sell.
To summarize: a high P/E does not necessarily mean a stock is overpriced. But it does mean that high expectations are built into the stock price. In the long run, if the company does not meet those expectations, its stock price is likely to fall, even if it is doing quite well. |
