1 when ‘p’ and ‘e’ spell profits p/e ratio can mean many things to many investors simple...

1

When ‘P’ and ‘E’ Spell Profits

P/E ratio can mean many things to many investors Simple definition: How much you pay per dollar

of stock’s earnings; A stock selling at $20 that earned $1 per share would have a P/E of 20.

More complicated definitions: Trailing P/E: Based on previous 12 months

earnings; Problem – past performance may not predict future prospects;

Future P/E: Based on predicted future earnings; Problems associated with predicting future earnings.

2

When ‘P’ and ‘E’ Spell Profits

Future P/E ratio is a function of several factors

Growth rate in earnings General condition of the market Firm’s capital structure; i.e.

required rate of return Current and expected Inflation Level of dividends, expected

dividend payout

3

When ‘P’ and ‘E’ Spell Profits An investor should know if a stock

has a P/E of 16, what does it mean? Is it trailing, current or future P/E?

P/E varies widely among companies and industries over time. Influenced by business cycle and interest rates.

Strong correlation between individual stock P/E and market as a whole; P/E rises during bull and shrinks during bear.

4

When ‘P’ and ‘E’ Spell Profits It is easy to misread P/E

Fast growing high-tech stock has high P/E Financial stocks rarely command high P/E

General rule of interpreting P/E: P/E over 20 is considered to be fast

growing, riskier firms Low P/E is considered to be matured, low

risk firms OR stocks that have fallen in hard times

Cyclical stock P/E tends to rise and fall with business cycle; if trailing P/E of cyclical stock falls to a single digit, it is time to sell

5

When ‘P’ and ‘E’ Spell Profits Competing theories of P/E:

Investing in low P/E stocks is less risky and more rewarding than high P/E stocks.

Those who buy low P/E stocks are called Value Investors – companies that are undervalued but possess excellent growth prospects.

Those who buy high P/E stocks are called Growth Investors – investors believe future earnings will rapidly drive up share prices.

6

What P/E Will the Stock Market Support? C. Barry White (FAJ, Nov/Dec2000)

History of P/E Reliable records of P/E began in 1926 Range of P/E from 1949 – 99 was 5.9

– 35 1970 – Stock prices driven up by the

“Nifty Fifty”-Sony, Polaroid, etc. Nifty Fifty companies P/E: 60 to 90 times, rest of S&P about 18

1973-74-Large cap stock as a group lost 37%; P/E fell to 7.

7

What P/E Will the Stock Market Support?

P/E Trends: 1949 – 61 : P/E from 6 to 22 1980 : down to 7 1988 : up to more than 30

Return Since 1995: 1995 : 37.4% 1996 : 23.1% 1997 : 33.4% 1998 : 28.6%Stock Prices grew faster than earnings.

Therefore, P/E expanded.

8


Factors that Influence P/E Past studies have linked P/E to:

Earnings growth Dividend payout Volatility of return Liquidity, etc.

9


Additional variables to be considered are:

Short-term rates (T-bills) Aggregate dividend yield Dividend payout ratio Money supply Federal Reserve P/E index Earnings growth GDP growth Volatility and total return of the S&P

500

10


Previous Studies Is P/E a good indicator for future returns?

Consumption drives stock returns Demand for and supply of equities Fama (JF 1991): an economy must

have increasing consumption to support higher earnings if higher equity prices are to be justified and sustainable.

11


Campbell and Shiller (JPM 1998): annual data, 1872-1997, studied stock return as a function of dividend yield

Historical mean of D/P=4.73% In 1997, D/P fell to 1.9% In the past, when D/P fell below 3.4%, stock

market always declined in real terms before it again crossed through the D/P historical mean.

High stock price and P/E are often justified by low inflation.

12


Goetzmann & Jorion (JF 1993): monthly data from 1927 through 1990; expected return increased strongly with higher dividend yield.

Good (1991): studied return as a function of P/E; quarterly data 1955-90; subsequent 12 month return could be predicted only when P/E is very high (>20) or very low (<8).

13


What Determines P/E? Expected earnings growth as a measure of

the earnings multiple. Problem: long-term earnings are difficult to

predict. P/E using constant growth:

P/E= (Do/E)(1+g) K-g

Thus: P/E positively related to payout Volatility of return increases, so does K,

this lowers P/E

14


Beaver and Morse: Volatility in earnings growth explain 50.5% of the variation in P/E. They used earning return (E/P) for the regression rather than P/E because E/P is believed to exhibit linearity whereas P/E does not.

15


Reilly, Griggs, and Wong (1983): 1962-80 S&P 400 data; inflation and risk free return have a negative correlation with P/E, but positively related to earnings growth, dividend to earnings, and business failure rate. Business failure rate was not a reliable P/E indicator.

Nomura Securities Study (1994): higher inflation depresses P/Es.

16


White (1997): Data from 1956-95 for S&P 500; multiple regression output: P/E is inversely related to GDP growth, inflation, and dividend yield.

Malkiel and Cragg (1970): Data from 1961-65 for 178 companies. P/E for individual companies are determined

by: Expected earnings growth (+) Dividend payout (+) Financial leverage (-) Volatility of operating earnings (-)

17


Kane, Marcus and Noh (1996): Monthly data for S&P 500 for 1954-1993 Concluded that standard deviation of

returns increases on a “permanent” basis, the market P/E will fall; P/E did not fall in 1987 because extreme volatility was not believed to be permanent.

Lagged P/E was the most powerful predictor of P/E.

18


Loughlin (1996): Quarterly data for 1968-93, S&P 500 Dividend payout (+) Five year T-notes (-) Expected Earnings (+)

19


Fairfield (FAJ 1994): Followed individual companies for 5 years over the period of 1970-84.

Focused on profitability and dividends as determinants of P/E and price to book value.

Findings: P/E was higher for companies having higher-than-average five year growth. Higher P/E was also associated with lower-than-average earnings growth for the current year; companies with temporarily depressed earnings had high P/Es.

20


Data: Quarterly time series data from 1926

through 1997; dividends and earnings are announced quarterly.

Test of multicollinearity was run, T-bill was discarded and T-bond yield was used.

Explain R2; t-values; F-value; d-stat;etc. Explain the model building process.

21

What P/E Will the Stock Market Support? Model:

Theoretical foundation of the model is as follows: Maginn and Tuttle (1990):

P/E= (B)(ROE)(D/E)/ E(K-g) B/E= book value/earnings (+) D/E= dividend payout (+) K= required return (-)

• Bodie, Kane, and Marcus (1993):

Po = 1 + PVGO E1 K E1

Po/E1 = forward P/E-current price divided by expected 12 month earnings

PVGO= PV of all future growth opportunities (+) For zero growth companies, P/E = 1/K

22


P/E and E/P are used as dependent variables. The Independent variable and their expected signs are presented in Table 1.

23

Independent Variable Expected Variable

Inflation Inverse

T-bond yields Inverse

T-bill yields Inverse

Dividend yield on S&P 500 Inverse

D/E Direct

Money Supply (MZ) Direct

FED P/E index Direct

Earnings growth Direct

Trailing volatility of returns Inverse

Trailing S&P 500 returns Direct

GDP quarterly growth Direct

24


Major Findings: Explain Table 2. In order of ranking (based on t-values) the

variables are: Dividend yield Dividend payout Total return (dividend and capital gain) FedPEX (inverse of current 10 year bond) Inflation

Based on 1999 Data: P/E should be between 18 to 23.

Can P/E be used for market timing?

1 when ‘p’ and ‘e’ spell profits p/e ratio can mean many things to many investors simple...

Documents

companies pe

theories of pe

range of pe

pe trends

individual stock pe

high pe stocks

low pe stocks

pe past studies