RISK IN THE MARKET ???????
S&P 500 P/E Now 26.2, or 23.5 if You
Prefer
Daily commentary updated for March 09, 1998
Earnings estimates are dropping, and stock prices are rising.
That is pushing valuations through the roof.
Earnings Data
The table below presents earnings data for the S&P 500 from
1997 and earnings estimates for 1998 as of March 5.
1997
1998
Estimated % Gain
As Reported
40.25
45.83e
13.9%
To Down Operating
44.87
48.47e
8.0%
Bottom Up Operating
44.87
49.79e
11.0%
Note: 1997 As Reported (including all charges and gains) data
from S&P, all others from First Call. Operating numbers exclude
one-time charges and gains.
Given a closing value of 1055.69 on the S&P 500 on
Friday, March 6, this leaves the price/earnings (P/E) ratios
as follows:
As reported trailing 12 months P/E = 26.2
Operating earnings trailing 12 months P/E = 23.5
Year ahead (1998) operating earnings top-down P/E = 21.2
Using any of these measures, the P/E is at extremely high levels.
As Reported vs. Operating Earnings
In recent years, the stock market has come to accept a wider
definition of what should be excluded from earnings data in
terms of determining the value of a company.
The simple fact is, any one-time charge or loss is a very real
accounting event that decreases the value of a company.
When a company takes a charge for acquisition costs, excess
inventory, discontinued products, or whatever, it is always a
negative event and often reflects bad management decisions. It is
not a good thing.
Yet, the stock market prefers to completely ignore these
items and instead look at "operating income." The theory is
that operating income reflects the future prospects for the
company and the "real" operations of the company. Behind this
assumption, though rarely noted, is that there will be no more
future, recurring, one-time charges that also cost the company
(and shareholder) money.
A better way of looking at one-time charges, in fact, is to
view them as costs to the company over a period of time.
Ignoring them altogether simply denies they exist. In the case of
a single company, it might make sense to virtually ignore
one-time charges because looking at them over an extended
period would have little impact. One-time charges for a company
that does not regularly engage in taking charges can generally be
ignored.
However, when aggregating 500 companies, the one-time
charges should not be ignored. Across a universe of 500
companies, "one-time" charges occur each quarter with
regularity. They are, in effect, recurring costs to the aggregated
companies. Acquisition costs, inventory write-offs, and bad
decisions occur on a regular basis for the overall S&P 500. They
are a cost of doing business.
Rose Colored Glasses
It used to be common to assess the earnings for the S&P
500 in terms of the "as reported" numbers, the honest to
God real numbers that companies posted, taking in all the good
with the bad. This still makes sense but is not commonly done
anymore.
Instead, the market now prefers valuation based on
operating income. After all, no one ever seems to care about
what one-time charges on individual companies represent, they
just want to know whether XYZ Corp. beat by a penny or came
in as expected, so why should they care in the aggregate. Not
only that, it makes current valuation levels at least a little more
reasonable.
P/E's Sky High by Historical Standards
Either way though, the current valuations are very high. On
an as-reported basis, the market P/E is now over 26. On an
operating basis, it is over 23. This compares to a historical P/E
on as reported numbers of about 17 or less for many decades,
and to one old rule of thumb that the market P/E should be 20
less the rate of inflation.
Of course, there is widespread belief that there is a new
paradigm, that the old measures just don't matter anymore.
Money is still money, however, and investments still need
to provide a rate of return. No matter what paradigm is
fashionable this week, the return on investments is still a function
of future profits, and the discounted present value of those future
profits based on an inflation/interest rate assumption. This raises
red flags for those concerned with valuation.
Earnings Projections Plummeting
As noted in Yesterday's Brief, first quarter earnings estimates are
falling fast. Even before the Intel, Motorola, and Compaq
warnings, the consensus estimate for first quarter year/year
earnings had fallen to +3.7% from about 15% as recently
as early January. Give it a few weeks and the number could be
getting disturbingly close to zero.
Even more worrisome is the fact that the current earnings
weakness is not all Asian related. It may represent a
slowdown in earnings momentum from the U.S. as well,
based on Disney, Intel, and Compaq statements.
Investors apparently believe that the current earnings
slowdown will be temporary, as has almost all bad news the
past few years. If so, then maybe earnings will start growing at
15% a year in the second half of the year. That is what investors
are apparently pricing stocks on now.
If that changes, however, and a belief develops that
earnings growth will slow for several years, then the
market is at serious risk.
Old Paradigm Still has Value
We have heard all the arguments: "where else are people going
to put their money," "buying on dips is the key to investing," etc.,
etc. That certainly has been true the past few years. But now, for
those who still like to look a little deeper, the slowdown in
earnings and rising P/E's are very troubling. Eventually,
earnings do matter, and if these warnings keep coming
out in as drastic a fashion as Compaq, investors should
have an understanding of what current P/E valuations are
and just how much earnings growth is slowing. |
