The Price/earnings Ratio: Time For A Second Look
The term "price/earnings ratio" is wedged so deep into stock market parlance that it seems to have been there as long as Wall Street itself. Not so. The concept actively entered the scene in the late 1960s, along with go-go fund managers with a fondness for statistics. Readers may recall the time when stock tables in newspapers reported the opening price of a day's trading, along with the stock's high, low, close, and volume. But alas, the opening price, a significant piece of market activity data, was dropped from the daily list in 1974 to make room for the P/E ratio.
Attentive investors were thus deprived of an important piece of information: how a stock behaved during a given day. For example, if a stock was down for the day but managed to close above its opening price, it actually performed quite respectably despite the decline. But unless he knows the opening price, an investor can't make that vital judgment.
The P/E ratio, on the other hand, has no similar day-to-day application.It remains basically static unless substantial changes in either price or earnings occur. The ratio is easy to calculate from other sources at hand -- except if a company suffers negative earnings or an anomalous quarter, in which case the idea must be shelved. All things considered, its daily inclusion adds little to an investor's information arsenal.
But there are more serious problems to consider if we assume that P/E ratios are useful measuring sticks. The premiums paid for growth and the penalties assessed for flat earnings have varied so greatly over the years that P/E ratios are no longer reliable indicators of how much to pay for a stock, if indeed they ever were. What are we to make of the fact that in the late 1960s the stodgy Dow Jones Industrials sold on average close to 20 times earnings, but that when the Dow crossed 1,000 recently the average multiple of these stocks was only 8.8? Are these 30 stalwart stocks worth only 44% as much today?
Or take the fast-growing INC. 100 stocks (INC., May, page 161). Their average P/E multiple works out to a lofty 36. But is this too high for a group of stocks whose average compound annual sales growth over the preceding five years was a whopping 89.4%? There's no definitive answer to this question, of course. But simple arithmetic shows that a stock with an average increase in annual earnings of 60%, a not uncommon rate among growth stocks these days, can close the multiple gap from a comparatively hefty 36 to the Dow's modest 8.8 in less than three years. That is, of course, if the stock price stayed constant, which it won't. The market recognizes and rewards such outstanding growth.
But not evenhandedly. An examination of both sides of the P/E ratio today shows that companies haven't stopped earning, but that investors have stopped bidding up most stock prices at a rate anywhere near that of earnings growth. Earnings of the almost 3,200 relatively active stocks on the New York and American Exchanges and the NASDAQ system have risen 114% as a group since 1976. This is about 16% compounded annually, well above the rate of inflation. But the average P/E multiple has declined from 12 in 1976 to 9 today. So the downtrend in P/Es does not reflect poor business, but rather demonstrates a stubborn refusal by investors to realize that ownership of common stocks could be the inflation hedge it once seemed to be. If 1976's average multiple of 12 had endured, instead of being 1,000 today the Dow would be at 1,364. If the Dow multiple had stayed at 20, the average would sit at 2,273.
Some investors will argue that without the P/E ratio there is no real way to establish the relative value of a stock. But even that is unclear. For example, the lowest multiple among the Dow stocks in late March was Texaco's 4.3. The highest was Merck's at 15.5. Yet Texaco's five-year earnings growth rate averaged 23%, while Merck's was only 13%. The relationships make no sense.
With or without a P/E, no one is ever sure whether a stock is overpriced or underpriced until it turns around and heads the other way, responding to the market's larger test of supply and demand. And that suggests that as more and more investors become convinced that the rapid growth rates of moderately capitalized companies like those on the INC. 100 are repeatable as well as exceptional, P/E multiples of 36, or even 100, should not be considered extreme.
If P/E ratios prove too vague to be useful in managing a portfolio, investors might devise a more dependable indicator of relative value, perhaps one based on return on stockholders' equity or on net profit margins. Better yet, bring back the daily opening price.
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