How to Interpret the Mythical, Magical P-E Ratio
Wall Street is gripped by quarterly earnings mania, but investors’ real concern isn’t what happened last summer--it is, what happens in ‘94?
The bears’ primary case against stocks is that they’re too expensive, meaning share prices relative to corporate earnings are too high.
The bears have a point. Using the Standard & Poor’s index of 500 mostly blue chip stocks, the market’s price-to-earnings ratio, or P-E, is now 18 based on average 1993 estimated earnings per share.
Since 1950, the S&P; 500 P-E has rarely exceeded 18; and very often, a rise to the 17-to-18 level has marked temporary market tops.
But a P-E is a moving target. Because it is the product of simple division, a P-E can come down in one of two ways: Either the numerator (stock prices) drops, or the denominator (earnings) rises.
The bulls’ case is that corporate earnings will be higher than expected in 1994, which means that the market P-E is lower than it appears. What’s more, say the bulls, rising earnings should give investors confidence to bid stocks higher next year, enough to leave the market’s P-E hovering around the historical peak of 18.
How the numbers shape up:
* Wall Street analysts’ current consensus estimate is that the S&P; 500 index will show earnings of $25.79 a share this year, according to earnings tracker Zacks Investment Research in Chicago. With the S&P; index at 463.28 now, divide that by $25.79 and you get 18.
* For 1994, analysts’ consensus estimate is for the S&P; companies to earn $28.82 a share. Divide that into 463.28 and you get 16.
Thus, if you assume that the analysts’ estimates are right--and that investors will be willing to pay as much for stocks a year from now as they do today (18 times earnings)--the S&P; index could rise 12% over the next year just to maintain the P-E at 18.
Admittedly, however, the assumptions in that calculation are huge. At this point, a 1994 earnings estimate is based more on hope than anything else. And even if analysts are right about earnings, other variables could pull down the perception of a “fair” P-E. Higher interest rates, for example, could make stocks less attractive, automatically undercutting P-Es.
It’s also worth noting that the S&P; earnings number is mythical. It represents a composite figure after calculating earnings-per-share expectations for each of the 500 companies in the S&P; index.
So while the “market” may appear reasonably priced, according to the S&P; earnings figure, that doesn’t tell you about individual stocks in the index. If earnings gains are concentrated in a relative few stocks in the S&P--and; the majority disappoint--a high market P-E isn’t sustainable.
The bulls say that the good news in third-quarter corporate reports so far is that earnings continue to improve in a healthy cross-section of businesses, including financial companies, industrial firms and technology firms. And in the case of industrial companies in particular, the earnings gains have occurred despite still-slow sales growth.
At machinery giant Caterpillar, for example, operating earnings leaped to 95 cents a share in the quarter from 5 cents a year earlier, even though sales grew just 6.3%.
William Dodge, stock strategist at Dean Witter Reynolds in New York, calculates that about half the S&P; 500 firms have reported third-quarter results, and that the aggregate earnings gain for those companies is 11.5% versus a year ago. Sales, in contrast, are up 4.5%.
“Sales are a little slower than expected, but the companies’ (profit) margins are better than expected,” Dodge says.
Some of Wall Street’s detractors contend that the rise in earnings is illusory. Take out the benefits of lower interest rates and corporate cost-cutting, and “core” earnings--the actual profit on product sales--may not look so exciting.
But Dodge argues that it’s wrong to view cost-cutting as merely a one-time benefit. The drive to boost productivity has become religion to American companies, he says. Even if sales grow faster than expected in 1994, Dodge sees no end to corporate efficiency efforts.
“Companies are going to be very slow to rebuild bureaucratic structures,” he says.
What’s more, that mentality has now spread from industrial America to consumer products companies, whose profit margins have been under pressure because of consumers’ tightfisted attitude toward spending. Last week three major drug companies--Pfizer, Upjohn and American Cyanamid--announced extensive job cuts.
If you want to paint an exceedingly bullish scenario for 1994, some experts say, this is it: Moderate U.S. sales gains boost industrial companies’ earnings; cost-cutting sparks a turnaround in consumer products companies’ bottom lines; and both groups benefit from an economic recovery in Europe.
At Prudential Securities in New York, strategist Greg Smith has weighed the potential boost to corporate earnings from all three of those factors and has adopted one of Wall Street’s most optimistic earnings estimates for 1994: He sees S&P; operating earnings at $36 a share. If he’s right, the S&P; index’s P-E is just 13.
For individual stocks, of course, P-Es can be much higher or lower than the average, depending on how investors judge a company’s growth prospects. The fastest-growing firms sport high P-Es; the slow growers get lower P-Es, as do companies whose earnings ebb and flow with economic cycles.
The point is, if earnings improve further in 1994, and investors gain confidence that the global economy can continue to expand into 1995 without serious increases in inflation or interest rates, there may be no good reason why P-Es should come down.
And remember: Just to maintain the S&P; P-E at the historical ceiling of 18, stocks would have to rise 12% on average next year, assuming 1994 earnings estimates are in the ballpark.
Are Stocks Too Expensive? The bears argue that stocks are priced exorbitantly; but based on expected 1994 corporate earnings, the market’s average price-to-earnings (P-E) multiple of 16 is below the historical peak of about 18. And despite the notion that all truly promising stocks must sell for high P-Es, this list--stocks most likely to outperform the market over the next three months, as judged by Zacks Investment Research--includes high and low P-E stocks.
Est. earnings/share: Stock P-E on Stock (market) 1993 1994 price ’94 est. General Instrument (N) $1.10 $1.54 $57 1/2 37 Zebra Technologies (O) 1.37 1.65 51 1/2 31 Aspect Telecomm. (O) 0.90 1.19 35 1/4 30 Oracle Systems (O) 1.77 2.28 61 27 Fiserv Inc. (O) 0.80 0.96 21 1/2 22 Dover Corp. (N) 2.59 2.93 56 3/4 19 Federal Express (N) 3.30 4.31 67 3/4 16 Dana Corp. (N) 2.70 3.80 58 15 Medusa Corp. (N) 1.42 1.95 25 5/8 13 Primerica (N) 3.15 3.75 44 5/8 12 Mercury General (O) 3.24 3.43 37 1/4 11 S&P; 500 25.79 28.82 463.28 16
N = NYSE; O = Nasdaq
1993 estimates represent company’s current fiscal year, which is either calendar 1993 or a fiscal year ending in the first half of 1994.
Source: Zacks Investment Research
