The P/E Ratio and new market metrics

Is the P/E ratio the next head to roll off today's market guillotine? What are the new market metrics which will mark the next generation of financial analysis? As usual the critiques are more abundant then proposed solutions.

Ben Levisohn:

The stock market's average price/earnings ratio, meanwhile, is in free fall, having plunged about 36% during the past year, the largest 12-month decline since 2003. It now stands at about 14.9, compared with 23.1 last September, based on trailing 12-month earnings results. Based on profit expectations over the next 12 months, the P/E ratio has fallen to 12.2 from about 14.5 in May.

Going off rational logic, these numbers would certainly have been prime time buy signals at any time in the past half century and change. Not so today.

The panic and uncertainty which can be attributed to a steady stream of usual suspects, has sedimented so firmly that very little tension is needed to cause inflammation.

As a result, even long valued mainstays of financial valuations, such as the P/E ratio are getting suspicious looks in regards to their ability to properly forecast for investing.

Some of you Wharton guys may hear the following words in class this semester:

Jeremy Siegel:
A stock is worth its future earnings, but that involves uncertainty. The more uncertainty there is, the lower the P/E will be.

Sounds simple enough, but on the downward slide of investing...what seemed a sure winner's bet in a bull market is the whitest of noise in volatility laced sideways markets.

Accounting for risk, if you think about it...is one of the most oxymoronic notions floating around the sea of variance and volatility.

Which begs the question: What is the future of valuation (not just P/Es) going forward?

It's hardly groundbreaking news that Wall Street has embraced more computational, quantitative, statistical, model driven set of valuations over the past decade. With the panic induced by the unpredictable side effects of algorithmic trading,however, not to mention the populist rage associated with black/gray box, ECNs and hedge funds...perhaps the "old school" valuation methods are as accurate as they have ever been. Maybe their time is now...

What is the correct step? Retrenching and focusing on long trusted fundamentals or pushing forward with an added zeal towards automatization?

I see a lot of people are licking their lips at today's P/Es...yet just as many (if not more) are not believing them at all.

Which one are you?

Comments (10)

Best Response
Sep 22, 2010 - 1:16pm
Midas Mulligan Magoo, what's your opinion? Comment below:

Here's the full article.

The Decline of the P/E Ratio

By BEN LEVISOHN

As investors fixate on the global forces whipsawing the markets, one fundamental measure of stock-market value, the price/earnings ratio, is shrinking in size and importance.

And the diminution might not stop for a while.

The P/E ratio, thrust into prominence during the 1930s by value investors Benjamin Graham and David Dodd, measures the amount of money investors are paying for a company's earnings. Typically, companies that post strong earnings growth enjoy richer stock prices and fatter P/E ratios than those that don't.

But while U.S. companies announced record profits during the second quarter, and beat forecasts by a comfortable 10% margin, on average, the stock market has dropped 5% this month.

The stock market's average price/earnings ratio, meanwhile, is in free fall, having plunged about 36% during the past year, the largest 12-month decline since 2003. It now stands at about 14.9, compared with 23.1 last September, based on trailing 12-month earnings results. Based on profit expectations over the next 12 months, the P/E ratio has fallen to 12.2 from about 14.5 in May.

The P/E ratio may not be vital anymore to investors or traders like Robert Gross, on the floor of the New York Stock Exchange on Aug. 11.

So what explains the contraction? In short, economic uncertainty. A steady procession of bad news, from the European financial crisis to fears of deflation in the U.S., has prompted analysts to cut profit forecasts for 2011.

"The market is worrying not just about a slowdown, but worse," said Tobias Levkovich, chief U.S. equity strategist at Citigroup Global Markets in New York. "People want clarity before they make a decision with their money."

Three months ago, analysts expected the companies in the Standard & Poor's 500-stock index to boost profits 18% in 2011. Now, they predict 15%. Mutual-fund, hedge-fund and other money managers put the increase at closer to 9%, according to a recent Citigroup survey, while Mr. Levkovich's estimate is for 7% growth.

"The sustainability of earnings is in doubt," said Howard Silverblatt, an index analyst at S&P in New York. "Estimates are still optimistic."

Equally troublesome, analysts' forecasts are becoming scattered. In May, the range between the highest and lowest analyst forecasts of S&P 500 earnings per share in 2011 was $12. Morgan Stanley predicted $85 per share, while UBS predicted $97 per share. Now, the spread is $15. Barclays said $80 per share; Deutsche Bank predicts $95.

When profit forecasts are tightly clustered, it signals to investors that there is consensus among prognosticators; when they diverge wildly, it shows a lack of clarity. The P/E ratio tends to fall as uncertainty rises, and vice versa.

"A stock is worth its future earnings, but that involves uncertainty," said Jeremy Siegel, professor of finance at the University of Pennsylvania's Wharton School. "The more uncertainty there is, the lower the P/E will be."

Not only is the P/E ratio dropping, it also is in danger of losing some of its prominence as a market gauge.

That is because, with profit and economic forecasts becoming less reliable, investors are focusing more on global economic events as they make trading decisions, parsing everything from Japanese government-debt statistics to shipping patterns in the Baltic region.

To some extent this is in keeping with historical patterns. P/E ratios often shrink in size and significance during periods of uncertainty as investors focus on broader economic themes.

P/E ratios fell sharply during the Depression of the 1930s and again after World War II, bottoming at 5.90 in 1949. They plunged again during the 1970s, touching 6.97 in 1974 and 6.68 in 1980. During those periods, global events sometimes took precedence over company-specific valuation considerations in the minds of investors.

There have been periods when the P/E ratio was much more in vogue. A century ago, the buying and selling of stocks was widely considered to be a form of gambling. P/E ratios came about as a way to quantify the true value of a company's shares. The creation of the Securities and Exchange Commission during the 1930s made financial information more available to investors, and P/E ratios gained widespread acceptance in the decades that followed.

But thanks to the recent shift toward rapid-fire stock trading, the P/E ratio may be losing its relevance. The emergence of exchange-traded funds in the past 10 years has allowed investors to make broad bets on entire baskets of stocks. And the ascendance of computer-driven trading is making macroeconomic data and trading patterns more important drivers of market action than fundamental analysis of individual companies, even during periods of relative calm. Journal Community

" People may be relying on P/E ratios less these days, but they will maintain their relevance in the end. The current drop in market P/E will simply create new opportunities for the savvy (and courageous) investor in the years to come. "

-Patrick Balester

So where is the P/E ratio headed in the short term? A few optimists think it could rise from here. If corporate borrowing costs remain at record lows and stock prices remain depressed, companies will start issuing debt to buy back shares, said David Bianco, chief U.S. equity strategist for Bank of America Merrill Lynch. As a result, earnings per share would increase, he said, even if profit growth remains sluggish, and P/E ratios could jump with them.

But today's economic uncertainty argues against that scenario. Consider that while P/E ratios dropped during the inflationary 1970s, they also fell during the deflationary 1930s. The one common thread tying those two eras of falling P/E ratios: unpredictable economic performance.

"We're looking at a more volatile U.S. economy than we experienced in the last 30 years," said Doug Cliggott, U.S. equity strategist at Credit Suisse in Boston. "The pressure on multiples may be with us for quite some time."

Sep 22, 2010 - 1:58pm
shorttheworld, what's your opinion? Comment below:

from what ive heard and read, a ton of money is still sitting on the sideline due to the economic uncertainty and also due to the fact that the economy is still considered crap and as such there is a lack of volume coming in.. when it eventually does, PEs are going to potentially 'normalize' a bit more as prices are dragged up from the buying influx.

when you were talking about black boxes doing 'computational' trading, you mean more so stat arb and HFT and the like that dont look at the fundamentals at all? since there definitely are fundamental black boxes.. i dont think either of them is going to disappear at all, there will be increased automation or at the very least more grey box things occuring but i dont think manual entry is going to disappear

Sep 22, 2010 - 2:37pm
Eddie Braverman, what's your opinion? Comment below:

LOL. I'm really not. I just get a kick out of it when bears (such as myself) try to out-bear each other with farther and farther fetched prognostications. And I actually like Prechter. But I think this prediction is a little loony.

Hell, the DOW was at 3,000 when I started in '92. It's gonna drop below that?

Sheee-it.

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Sep 22, 2010 - 6:26pm
LIBOR, what's your opinion? Comment below:
Edmundo Braverman:
LOL. I'm really not. I just get a kick out of it when bears (such as myself) try to out-bear each other with farther and farther fetched prognostications. And I actually like Prechter. But I think this prediction is a little loony.

Hell, the DOW was at 3,000 when I started in '92. It's gonna drop below that?

Sheee-it.

If we get all Japanese:

http://finance.yahoo.com/q/bc?s=^N225&t=my&l=on&z=l&q=l&c=

looking for that pick-me-up to power through an all-nighter?
  • 1
Sep 22, 2010 - 5:34pm
mxc, what's your opinion? Comment below:

Forward EBITDA multiples

Sep 22, 2010 - 9:50pm
Czech-yo-premiz, what's your opinion? Comment below:

No one knows where the market will go the only guaranteed number is Dow = 0. Bottom line is that it is a very confusing time for all. It is very hard for MM funds given how low yields have gone, but 2008 is still painful and fresh.

Throw in a political mess and the real question becomes not where the Dow will go, but how much pain can you stand in terms of your absolute equity exposure.

Sep 23, 2010 - 3:52am
adapt or die, what's your opinion? Comment below:

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