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When ‘P’ and ‘E’ Spell Profits

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- 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.

- 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

- 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.

- 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

- 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.

- 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.

- 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.

- Factors that Influence P/E
- Past studies have linked P/E to:
- Earnings growth
- Dividend payout
- Volatility of return
- Liquidity, etc.

- Past studies have linked P/E to:

- 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

- 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.

- Is P/E a good indicator for future returns?

- 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.

- 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 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

- P/E= (Do/E)(1+g)
- Thus:
- P/E positively related to payout
- Volatility of return increases, so does K, this lowers P/E

- 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.

- 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.

- 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 (-)

- P/E for individual companies are determined by:

- 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.

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

- Dividend payout (+)
- Five year T-notes (-)
- Expected Earnings (+)

- 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.

- 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.

- 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

- Maginn and Tuttle (1990):

- Theoretical foundation of the model is as follows:

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.

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

- 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?