The price/earnings ratio is without doubt the most common metric used by investors to evaluate the relative attractiveness of a stock and of the stock market. This article takes a look at the Price/Earnings ratio in the following four contexts:
- The relationship to cash flow
- Historical perspectives in light of recent Financial Accounting Standards Board rule changes
- The impact of Standard and Poor's recently announced Core Earnings definition
- The usefulness of this metric as a market timing tool
Relationship to Cash Flow
Determining price is the easy part. We run into difficulty when we try to determine a universally acceptable definition for “earnings”. Using Generally Accepted Accounting Principles (GAAP) we can define earnings as the most recent four quarters actual, estimated earnings for the remainder of the current fiscal year or the estimate for the coming fiscal year.
If this is not confusing enough, we have seen a variety of non GAAP earnings estimates in recent years with names such as “cash earnings”, “operating earnings”, or “pro-forma earnings”, none of which has any basis in formal accounting theory; rather, they were meant for internal managerial purposes. This did not prevent them from being widely accepted and promoted during the stock market bubble of 1999-2000. Eventually, reality struck with a vengeance, and suddenly the earnings-before-the-irrelevant-expenses-metrics no longer are in vogue.
What are these “irrelevant” expenses? Just such as depreciation, amortization, interest and pension obligations, of course. These are an integral part of the operations of every major corporation.
Buying stock in a company is a lot like buying a company itself. A rational buyer tries to figure out whether the cash he or she will receive out of the business over time will exceed the cash he or she must put into it over time. Although buying a small share of
ownership in the form of common stock carries a liquidity premium, the idea is the same. An investor expects management either to reinvest the cash generated by the business and earn a higher rate of return or send some back as dividends.
Many common accounting ratios attempt to get a handle on the cash flow-generating capabilities of a company. These include the price/sales ratio, or how many times annual revenue per share the stock price is, and the profit margin or earnings/revenue. These three are related as follows:
Price/earnings = price/sales ÷ earnings/sales (profit margin).
GAAP can distort earnings vis-à-vis cash flow over short time periods simply due to the differences between cash and accrual accounting. The differences should wash over time in that earnings should equal cash flow over successive periods of several years. When earnings, sales, and cash flow increase in line with each other, generally it is an indication that bottom-line growth is being generated by unit-volume growth and high operating margins rather than deferred taxes, investment gains, asset sales, or a lower than optimal reserve for doubtful accounts.
FASB Rule Change
Professional investors routinely use price/earnings ratios to gain a historical perspective regarding the relative attractiveness of common stocks versus other investments. Recent changes instituted by the Financial Accounting Standards Board (FASB) in how companies account for goodwill will distort the historical perspective of the price/earnings ratio for the next several years. Simply put, companies will no longer amortize the goodwill that is on their balance sheets by taking a periodic charge on their income statements. Nonetheless, this change will bring increased comparability to reported earnings and cash flow across companies within a given industry.
The upshot here is that since companies will no longer have goodwill amortization expense on their income statements, reported earnings will be higher as will total assets and shareholder equity.
What will be the impact on stock prices of these changes? Since cash flows will remain the same, nothing fundamental really will have changed. Hence, p/e ratios will adjust downward or stock prices will adjust upward. Some investors will think that a stock is attractive simply because it now trades below its historical p/e multiple. The greatest impact here will be seen for those companies that have done large acquisitions in recent years.
Standard and Poor's Core Earnings
In light of the numerous corporate accounting scandals uncovered in the past year, investors have been questioning the reliability of reported earnings of many major corporations. The question of “just what really are earnings?” is one that investors keep asking. Spurred by this, Standard and Poors recently announced its “Core Earnings” computations for the S&P 500 index. S&P's objectives are to provide consistency and transparency to earnings analyses and make it easier for investors to form comparisons between companies and over different time periods. This should bridge the gap between companies using the ill-defined “pro-forma” earnings or “operating earnings” concepts and generally accepted accounting principles (GAAP).
For the twelve months ended June, 2002, As-Reported Earnings per Share for the S&P 500 were $26.74. Core Earnings per Share came to $18.48. The largest adjustments were for Employee Stock Option Grants (-$5.21) and Net Pension Adjustments ($-6.54). These numbers compare to Operating Earnings, the preferred Wall Street figure, of $41.58. With the S&P 500 at 900 as of this writing, the price/earnings multiples would be as follows:
|As Reported Earnings||33.65X|
At the end of the second quarter, the S&P was at 990; hence, these numbers would each be higher by 10%.
In addition to Employee Stock Options and Pension Plan Adjustments, S&P does not add back so-called “one time restructuring charges,” which most companies do not consider when computing operating earnings although they must be included as expenses under generally accepted accounting principles. The following table summarizes these differences:
Core Earnings Differences
|Stock Option Expense||Excluded||Excluded||Included|
|Included||Included||Excludes pension fund gains and includes service & interst cost|
|Goodwill||Excluded||Excluded||Excluded unless impaired|
|Restructuring Charges & Writeoffs||Excluded||Included||Included|
|Purchased Research & Development||Excluded||Included||Included|
Now that this is all perfectly clear (just kidding), what will be the likely impact of these changes in reported earnings on stock prices going forward?
Although this may seem counterintuitive to some, there is little evidence that market timing based on the average price/earnings ratio for a market index provides any advantages to investors! It is best to use p/e ratios when deciding to buy individual stocks.
In an article in the fall 2000 Journal of Portfolio Management, Meir Statman, a Santa Clara University finance professor, and Ken Fisher, a California based money manager, statistically showed that there is no linkage of market p/e ratios to subsequent returns in the market. This proved true whether the time horizon was short or long, up to five years. Simply put, high p/e markets do well just as often as they do poorly. Similarly, low p/e markets do poorly just as often as they do well. The same conclusion applies when using specific entry/exit price /earnings ratios.
The bottom line should come as no great surprise. Buying and holding beats market timing. How come? Because you will miss rallies when you are out of the market and you still will incur corrections when you jump back in the market. Since the 1920's, the best sixty-five months, less than one per year on average, have provided nearly all of the markets gains!
Does this mean that the price/earnings ratio is useless? Not at all. Rather, it is still a good indicator of long-term value and risk. Twenty years ago, the Dow Jones Industrials average was approximately 800, the dividend yield was about 6%, and the p/e multiple was about 7X. Of course, interest rates were in the high teens, and inflation was in the double digits.
The scenario is quite different today. The price/earnings multiple today is certainly much higher, regardless of which method is used to determine it.
This means that risk has increased and the potential long-term rewards have necessarily diminished. Passive investing will not produce the mid-teens average returns as was the case in the 1980's and 1990's. The bear market of the past two years and nine months has wrung the greatest excesses out of the market.
Stocks still are not really cheap, but they are attractive, especially in light of depressed corporate earnings, historically low interest rates, and a non-inflationary economy. We anticipate average stock market returns of 7%-8% for the balance of the decade, and this includes dividends. And, as I wrote just four months ago, investors who focus on stocks with above-average dividend yields and faithfully reinvest these payouts stand a much better chance of outperforming their more growth-oriented peers, with less risk, to boot.
The Lane Report is a publication of The Law Offices of Marc J. Lane, a Professional Corporation. We attempt to highlight and discuss areas of general interest that may result in planning opportunities. Nothing contained in The Lane Report should be construed as legal advice or a legal opinion. Consultation with a professional is recommended before implementing any of the ideas discussed herein. Copyright, 2003 by The Law Offices of Marc J. Lane, A Professional Corporation. Reproduction, in whole or in part, is forbidden without prior written permission.