The most popular way to try to determine the value of
overall market is valued by use of the Price to Earnings (PE) ratio. The idea behind the use of this metric is
that investors should generally be buyers when the ratio is low and generally
be sellers when the ratio is high.
PE’s are simply determined by dividing price by
earnings. We can determine what the
expected earnings will be given a set of different PE ratios for any level of
the market. Below is a table that shows
different implied Earnings Per Share (EPS) levels for
the S&P 500 as a whole given different PE ratios.
|
Current S&P Level*
|
|
910.33
|
|
PE Ratio
|
Implied EPS
|
|
5
|
$ 182.07
|
|
7
|
$ 130.05
|
|
9
|
$ 101.15
|
|
10
|
$ 91.03
|
|
11
|
$ 82.76
|
|
12
|
$ 75.86
|
|
13
|
$ 70.03
|
|
14
|
$ 65.02 |
|
15
|
$ 60.69
|
|
16
|
$ 56.90
|
|
17
|
$ 53.55
|
|
18
|
$ 50.57
|
|
19
|
$ 47.91
|
|
20
|
$ 45.52
|
|
21
|
$ 43.35
|
|
22
|
$ 41.38
|
|
25
|
$ 36.41
|
|
28
|
$ 32.51
|
|
30
|
$ 30.34
|
|
As of close 5/26/09
|
It is worth noting that I completely disagree with this faux
analysis, whereby a person can determine whether the market is a “good value”
based on the minimal computational skill required to determine a PE ratio. Key among my concerns is that this
methodology gives no thought to Balance Sheets, forward debt obligations, or
anything else. But this is the type of
analysis that many of the media personalities point to in an effort to make a
case as to whether or not stocks are a “buy.”
At best it is faulty analysis to rely on “guesstimates” of future
earnings and assign a PE level to that number as a method to determine prices
of equities.
The Right PE Level: A Moving Target
As mentioned earlier, the idea of using the PE ratio is for
investors to be buyers when the ratio is low.
However, picking a PE ratio that is “low” requires the ability to
determine the level of earnings in the future.
Most investors do not actually attempt to determine earnings going forward,
but instead rely on the estimates of other agencies whose estimates have been
substantially different from actual results in the past.
It is important to recognize that should such a rebound in
earnings fail to materialize, it is highly likely that investors are not buying
PE’s when they are low, but instead buying when they are high. The effect on equity prices can be fantastic,
and the percentage losses can be severe.
Caution should be exercised when it comes to reliance on “forward PE
ratios.”
PE as a Proxy for Analysis
In my opinion, there is simply too much faith involved in
the earnings estimates of a broad market index.
As prices go lower, “now is the time to invest” seems to be a redundant
talking point. This is based on the idea
that earnings will return to a normal value, and the economy will once again
continue to resume expansion in the near future. This may be the case, it may not.
The core problem I have with the PE ratio analysis is that
it is a relative measure; it is intellectually lazy. As equity prices decline, they look cheaper,
when in fact, they are not; prices are just lower than they were before. I am sure that people thought the Nikkei was
a bargain when it declined from near 40,000 to 30,000. It must have been an absolute steal when it
declined to 20,000. It is going on 20
years later, and the Nikkei currently stands at near 9,500. The apparent bargains were not actual
bargains.
In essence, broad market valuations are determined by speculative
and flawed PE ratios. More importantly, investment in the broad market capitulates
to the decisions of others. I find the
main benefit of PE ratio analysis claimed by analysts in favor of broad equity
market investment—diversification— to be a poor reason to abdicate decisions to
others. It is much better to focus investment in a few particular enterprises,
rather than the entire market as a whole.
RSS
1 Comment
The hard data support this view. In his book "Practical Speculation" at pp. 50-59, Victor Niederhoffer looks at various statistical studies of his own and others and concludes that there is no statistically significant relationship between the overall level of P/E ratios and future market performance. He notes that "In sum, our studies show the relation between P/Es and returns from 1950 to 2001 is completely consistent with randomness . . . " and that "Kenneth L. Fisher and Meir Statman, in a definitive study covering the years 1872 through 1999, also concluded that P/Es provide unreliable forecasts of future returns." The methodology behind the assertions made by Robert Shiller in his book "Irrational Exuberance" regarding the significance of overall P/E levels is criticized.