Price-to-Earnings Gap Is Worrying Wall St. Veterans
If the P/Es of big-company stocks look too high, don’t blame it on the E.
U.S. blue-chip companies’ fourth-quarter earnings--the E in the price-to-earnings ratio--are estimated to have risen 22% over the year-ago quarter, according to First Call Corp.’s tracking of firms in Standard & Poor’s 500 index.
That surprisingly robust performance is only slightly below the 22.7% earnings growth of the third quarter, and reflects the strength of the U.S. and world economies, analysts say.
But even as earnings overall continue to rise, many companies may well wonder whether investors are paying attention. Except in the red-hot technology sector, the stock market so far this year doesn’t seem to be rewarding earnings growth.
Although many tech stocks have continued to rocket, the S&P; is down 3.6% this year. The Dow industrial average, which fell 55.53 points to 10,643.63 on Thursday, is off 7.4% for the year.
Meanwhile, the tech-dominated Nasdaq composite soared again Thursday, rising 2.8% to a record 4,485.63 and lifting its year-to-date gain to 10.2%.
Yet some analysts say it isn’t a case of investors ignoring earnings gains in the broad market. Rather, profit growth has been fighting rising interest rates to a standstill in investors’ calculations of what most stocks are worth, argues Anthony F. Dwyer, market strategist at Kirlin Securities in New York.
If earnings were weaker, interest rate fears would dominate and the non-tech issues--that is, most of the market--would lag even further behind, Dwyer said.
Still, many veteran Wall Streeters are amazed, and worried, by the widening gulf between the stock prices investors are willing to pay for tech companies, relative to earnings, and the prices they’re willing to pay for the rest of the market--such as financial companies and basic-materials firms, two sectors that racked up stronger-than-expected fourth-quarter earnings.
The P/E gap between the headiest tech names and the also-rans is perhaps as wide as it has ever been, analysts say.
Legg Mason strategist Richard Cripps noted this week that although the top 50 S&P; 500 stocks are trading at an average P/E of 75 based on most recent 12 months’ earnings per share, the average P/E of 1,800 stocks tracked by Value Line is just 14.5.
The overall S&P; P/E, at about 29, thus is grossly inflated by the index’s tech stocks.
It’s true that the tech sector, as usual, provided much of the power behind fourth-quarter S&P; profits. And a cardinal rule of investing is that investors should pay higher P/Es for faster-growing companies.
But should there be a “cap” on what a tech stock is worth?
Computer networker Cisco Systems illustrates what some analysts think is wrong with the market. The stock currently is priced at about 175 times its most recent 12 months’ earnings per share. And even though Cisco’s earnings are expected to grow at 30% or better each year, the P/E is sky-high even based on future earnings.
“Do I want to buy Cisco at 100 times mid-2001 profit estimates?” asked Hugh A. Johnson Jr., chief strategist at First Albany Corp. “I love the . . . growth, but that’s too high a price.”
The same is true of Sun Microsystems and Oracle--consistent 30%-plus growers now selling at 80 times 2001 earnings, he said.
“I’m thankful I own them, but I’m not comfortable,” Johnson said.
Although tech companies’ growth outlooks are stellar, their stocks’ P/Es now are three to four times or more their earnings growth rates. For many “old economy” stocks, by contrast, P/Es often are less than twice expected growth rates.
Of course, some good earnings reports outside the tech sector can still draw an audience.
On Thursday, oil giant Royal Dutch Petroleum reported rising profits and falling expenses. Investors listened and bid the shares up $2.63, or 5%, to $54.63 on the New York Stock Exchange.
It was a good day for Royal Dutch, but it’s not much of a year: The stock still is trading well below its 52-week high of $67.38.
Will the market’s laggards ever get their due?
“Ultimately, stocks reflect their value,” Kirlin’s Dwyer said. “It’s just a patience game.”
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The Bottom Line vs. the Market
Earnings of blue-chip U.S. companies in total rose more than 100% between 1992 and 1999, which supported the stock market’s surge in that period. But the market itself, as measured by Standard & Poor’s 500 stock index, performed far better than underlying earnings: The S&P; rocketed more than 200% in that period. The result: much higher stock prices relative to earnings--a situation that has been most pronounced among technology stocks.
*
* Based on most recent four quarters’ earnings per share
** For next five years
Sources: Goldman Sachs & Co., Zacks Investment Research, Times research
