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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:

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when p and e spell profits
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.
when p and e spell profits1
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
when p and e spell profits2
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.
when p and e spell profits3
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
when p and e spell profits4
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.
what p e will the stock market support c barry white faj nov dec2000
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.
what p e will the stock market support
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.

what p e will the stock market support1
What P/E Will the Stock Market Support?
  • Factors that Influence P/E
    • Past studies have linked P/E to:
      • Earnings growth
      • Dividend payout
      • Volatility of return
      • Liquidity, etc.
what p e will the stock market support2
What P/E Will the Stock Market Support?
  • 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
what p e will the stock market support3
What P/E Will the Stock Market Support?
  • 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.
what p e will the stock market support4
What P/E Will the Stock Market Support?
  • 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.
what p e will the stock market support5
What P/E Will the Stock Market Support?
  • 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).
what p e will the stock market support6
What P/E Will the Stock Market Support?
  • 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
what p e will the stock market support7
What P/E Will the Stock Market Support?
  • 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.
what p e will the stock market support8
What P/E Will the Stock Market Support?
  • 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.
what p e will the stock market support9
What P/E Will the Stock Market Support?
  • 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 (-)
what p e will the stock market support10
What P/E Will the Stock Market Support?
  • 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.
what p e will the stock market support11
What P/E Will the Stock Market Support?

Loughlin (1996): Quarterly data for 1968-93, S&P 500

  • Dividend payout (+)
  • Five year T-notes (-)
  • Expected Earnings (+)
what p e will the stock market support12
What P/E Will the Stock Market Support?
  • 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.
what p e will the stock market support13
What P/E Will the Stock Market Support?
  • 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.
what p e will the stock market support14
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
what p e will the stock market support15

What P/E Will the Stock Market Support?

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

slide23

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

what p e will the stock market support16
What P/E Will the Stock Market Support?
  • 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?
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