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When ‘P’ and ‘E’ Spell Profits

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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
• 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 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 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 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 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.
• 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?
• 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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 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

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?