What Wall Street sees when it looks at your P/E ratio.

What Wall Street sees when it looks at your P/E ratio 

What goes into the analysis that potential investors apply to your financial statements? Read on for a primer on the often complex formulae that spell "yeah" or "nay" to investing in your firm. The executive turned to the financial analyst and inquired why their company's price/earnings ratio was below those in their peer group. The analyst produced a graph of the historically up-and-down earnings pattern of the company and, indicating the lowest point on the graph, replied, "I think this is where we went wrong."

If you review the price/earnings ratio's relationship to the four principle methods of stock valuation, earnings emerge as a primary driver of a company's stock price. Earnings have many characteristics. Current and expected earnings, consistency, quality, momentum, sustainability, as well as the role of earnings in cash flow analysis, are all important aspects of the role of earnings in stock valuation.

Stock valuation models are used extensively by institutional researchers and investors to identify investment candidates. These models reflect four concepts: dividend discount, asset valuation, cash flow analysis, and relative valuation.

Model #1: Dividend discount

The dividend discount model values a stock price as the present value of the stock's future dividend stream, discounted by the current interest rate. If an investor in an equity instrument expects to derive returns over the long term from the net income of a corporation in the form of dividend or asset accumulation, he has to look to the future for the expected return.

The tool most often used in determining the expected return is the P/E ratio. The P/E ratio is defined as the mechanism in which present earnings are capitalized. For example, if a company earns $1.50 per share for a given fiscal year and the stock price is $15 per share, the investor is willing to pay 10 times the current earnings to become an owner of the company.

If the company continues to earn $1.50 for a very long time, the investor will receive a 10-percent return on the original investment (earnings/price paid), which the company either distributes in dividends or uses to increase assets. However, if the earnings of the company grow by 10 percent per year, everything else being equal, the company would earn $3.00 per share seven years later. The return on the original investment would actually be 20 percent. This example introduces the element of expected growth into the formula of determining the P/E multiple, the actual rate of the capitalization of earnings.

Current earnings and expected earnings, as illustrated in the previous example, are two of the three variables that influence the P/E ratio. Since companies do not operate in a vacuum, a third variable, the general market valuation, is introduced.

The general market valuation is the value of alternative investment opportunities. Alternative investment opportunities are driven by the prevailing level of interest rates. Even if management performs well, a stock price may languish because the discount factor investors apply to its dividend and earnings prospects may increase due to rising Treasury bond yields and the increased risk attributed to investors holding diversified portfolios of stocks.

The expected growth rate of earnings is worth more when interest rates are lower. As a general measure, with long-term Treasury rates at 10 percent, the market multiple would be about 10 times earnings; with Treasury rates at 8 percent, the multiple would be 12.5 times earnings. The Dow Jones P/E was a bit higher than 6 at the 1982 bear-market low, when interest rates fluctuated around 20 percent. The multiple did not decline to 5 or less perhaps because of the underlying book values and the relationship of the price to the net book value as discussed in the following section, return on net assets.

Conversely, companies' P/E multiples soared to 40 or more times earnings in 1968 and 1972, when interest rates were much lower. Interest rates at this time were 5 to 6 percent, but future growth expectations were very high.

There is also a strong inverse correlation between the long-term inflation trend and the P/E multiple. During inflationary periods, P/E ratios have ranged between 5 and 10. The ratio rises to between 15 and 20 in disinflationary or deflationary times.

A rule sometimes cited is that stock market conditions determine 50 percent to 55 percent of a stock's performance, the industry group determines 30 percent, and the company itself represents 15 to 20 percent. The 50 to 55 percent attributed to stock market conditions may be justified by the fact that the P/E reflects the market, which in turn reflects interest rates. Conversely, interest rates reflect the market, which is reflected by the P/E multiple. However, a flaw in the industry group theory, which determines 30 percent, is it incorrectly assumes a stock has no unique characteristics. An example is SmithKline Beecham and its Tagamet product for treating ulcers, which afforded it a multiple well above the average for the pharmaceutical group at the time the drug was introduced.

Data going back to the 1930s shows conclusively that stocks with low P/Es outperform stocks with high P/Es over the long term in virtually every period analyzed. More recent studies show similar results. Over the long term, a low P/E strategy enables investors to outperform the market and is valid regardless of the market performance at any particular time.

There are two reasons why this strategy works. First, a high P/E by definition has high expectations for earnings growth. Indeed, it discounts all good news and opens the door for a rapid adjustment in the price (and hence the multiple) to lower expectations when disappointing earnings are reported. Second, a low P/E stock may be relatively unknown and not yet have a strong analyst following. Chances are higher that a neglected stock is undervalued than that a popular issue is.

Low P/E multiples become high P/E multiples when expectations change. A good example is the telephone industry's traditionally low multiple, which changed as new technology (such as cellular telephones and fax machines) increased demand and deregulation enhanced earnings. Unless expectations change, however, a low P/E stock could retain its deserved low multiple.

Model #2: Return on net assets The second major method of equity evaluation is return on net assets, including asset valuation. Asset valuation assumes the market price of a stock selling below its book value will rise toward this value if the book value reflects the true current value of the assets, whether appreciated or depreciated.

If the net assets (total assets minus total liabilities) per share are below the current market price, the assumption is that current management is failing to generate adequate returns from the company's assets. There are two approaches to this analysis.

First, by taking current net income and dividing by the net asset value (book value per share), a potential investor can figure the current return to shareholders, which could be below that offered through competitive financial instruments. Second, the valuation of the assets could have appreciated significantly beyond the depreciated (historical cost) basis. Thus, if the assets are marked to market and net income is divided by a larger base of net assets, the return may not be competitive. An inadequate return could be remedied by selling assets or better utilizing the assets in order to earn a higher return.

A Bear Stearns strategy paper entitled "Don't Earnings Matter Anymore?" states, "In this century, with the exception of the early 1930s, variations in price/earnings multiples have dominated the movements in stock prices. Anticipating shifts in P/E--the value of earnings--is the dominant investment consideration for the stock market."

Movement in the P/E indicates the capitalization rate is being changed. The willingness of investors to capitalize at a different rate changes due to the increased visibility of earnings (a long-term focus) or the certainty of earnings (in the short term).

Studies from Oxford University and the University of Chicago indicate that, except for the immediate future, past earnings growth is almost useless in predicting future earnings growth. Ironically, most analysts still extrapolate from the past into the future even though the margin for error is high. Indeed, a Forbes review found that, in mid 1985, the 1986 earnings growth that analysts projected for high-multiple companies was 73 percent higher than the actual results.

A Harvard Business School study of estimates for 1,250 companies for the five-year period ended in 1981 confirms this. The analysts' consensus estimates for less than 12 months in the future were off by an average of 30 percent. Yet it must be noted that past performance is the sole basis on which the impact of change can be intelligently forecast.

In the real world, forecasting is difficult. The more successful a company becomes, the more competition, government controls, and market saturation dampen its results. Cost increases that cannot be passed on to customers, economic vagaries, and new technology impact even the most stable companies.

In a study of the top 250 growth stocks between 1950 and 1980 to determine the characteristics of the best performing stocks, earnings momentum was found to be crucial to the stocks' performance, as was industry strength. The rate of growth in corporate earnings has a direct impact on the multiple: the higher the growth rate, the higher the multiple. As a general measure, the P/E should usually equal a company's expected rate of growth.

The expected sustainability of the growth rate is equally important. The stock market is risk averse and will provide a premium for dependability and predictability. Consistency through lower, but even, increments are worth more than two "down" and three "up" years in a five-year period.

A steady pattern of earnings growth is enhanced by management's openness in discussing the company's strategy. However, "want to do" and "can do" are two different concepts, and management must not say one when it means the other. A company may lose a hard-earned multiple if a strategy for growth, touted by management, falters and the financial community adopts a show-me attitude towards the stock. In a stable market, the price of the stock for a company caught in such an event can remain unchanged for one or two years until confidence is once again restored and a consistent earnings pattern for the stock is reestablished.

Quality-of-earnings analyses are used to determine the probability of earnings trends continuing and the extent to which earnings could represent distributable cash. High-quality earnings are defined as earnings that can be distributed in cash and are derived primarily from continuing operations that are not volatile from year to year. Conversely, low-quality earnings have only a small percentage of distributable cash and are derived primarily from non-operating sources.

Examples of low-quality earnings include changes to more liberal accounting estimates, a non-recurring item contributing significantly to results, an unusually large increase in deferred tax expense, or earnings that are cyclical (such as the earnings of commodity companies) or subject to wide variations due to uncontrollable forces such as weather. Companies with high-quality earnings command a higher P/E than companies with low-quality earnings even though these companies may be similar in other respects.

Model #3: Cash flow analysis

The third major method of evaluation is known as the cash on cash returns approach, or cash flow analysis. Under this method of evaluation, depreciation and other non-cash expenses are added to after-tax net income to project the pure cash flow of a company. (Some institutions use an alternate method known as a multiple of the EBDIT--earnings before depreciation, interest, and taxes.) Although net income could be depressed by a high depreciation expense, the company could generate very attractive cash flows.

Companies with a high figure as cash available for dividends or share repurchases usually are afforded a higher P/E relative to other companies in their peer industry group.

Model #4: Relative valuation

The relative valuation approach dictates that the P/E multiple of a stock should have approximately the same relative relationship to the P/E multiple of some general market index as does the stock's earnings growth rate or return on equity. Relative P/E analysis is the most extensively used valuation approach.

However, because of its reliance on historical cost accounting (earnings per share and stockholders' equity), its value has been challenged in recent years as acquisitions, takeovers, and restructurings have increasingly reduced the comparability of historical data over time and between companies.

The P/E multiples of the S&P 500 or 400 are the usual barometers in evaluating a stock relative to the market. The relative valuation method compares a stock's current and past multiple to a current or past multiple for the market.

For each industry or security, charts display the P/E, ROE, dividend yield, price, and earnings per share for the current year, previous years, and the next year forecasted relative to the same data for the market (S&P 500 or 400 data). If the relationship between the current relative P/E ratio based on projected earnings and the projected relative return on equity differs substantially from the past relationship indicated on the charts, then a relative over- or undervaluation may exist and present a selling or buying opportunity.

There is a risk, however, to investing on a relative basis since the investor must make two forecasts: one for the company and one for the market level. For this reason, while this investment method can be successful, it may also sustain significant losses if the investor's estimates of either or both of the forecasts prove to be inaccurate.

The "E" of earnings

A study was conducted of 300 institutional portfolio managers and analysts, most of whom manage more than $500 million for their own or client accounts. Of the respondents, 40 percent ranked the P/E ratio as the key factor in picking stocks (i.e., 40 percent would pay for earnings at a given price), while 35 percent rated present and near-term earnings potential as most important (i.e., 35 percent wanted earnings regardless of what they paid). Management strength was the key factor for 23 percent (and indeed management strength produces stronger earnings). Next in line were return on investment (13 percent), the earnings growth record (11 percent), and market share (10 percent). In effect, the majority of the participants considered earnings to be the most important component in selecting stocks, with 86 percent specifically citing the P/E (which contains the "E" of earnings), earnings potential, and earnings growth.

The P/E ratio enters into each of the major methods of stock evaluation because of the earnings component and, relative to the market, does not change unless expectations change. Corporate management must therefore focus on the quality and growth of current and future earnings and the consistency and reliability of those earnings. A wise man's words are well taken: "Expectations, both current and future, drive the P/E multiple. It's a bit like life."