`Did you understand that P/E stuff?” one young woman asked her friend as they left a Dean Witter investment seminar in Bloomington, Minn., recently.
“No,” her friend replied. “But don’t worry about it. All that matters is your returns. If they are going up, you are doing fine.”
I gulped when I heard that and debated whether I should suggest that focusing simply on last quarter’s returns alone could be the road to disappointment for an investor. But I decided to hold my tongue and instead give you my two cents’ worth on the issue.
“P/Es” (price-to-earnings ratios) do matter if you’re buying stocks or stock mutual funds.
In fact, they and other tools help you understand whether you’re paying a fair price for a stock. But after riding a bull market for years, many investors–not just the two affluent young women I overheard–have become cavalier about the fundamentals.
What’s important about P/Es isn’t necessarily that you start doing your own number-crunching, although you or your investment adviser should be doing at least a few calculations to make sure the price you pay for a stock makes sense.
And I’m not arguing that you use either a high P/E or a low P/E as a litmus test for the stocks you choose because different P/Es are appropriate for different industries.
But what every investor should know, whether you’re a do-it-yourselfer or rely on an adviser, is that over time stock prices don’t go up unless corporate profits (earnings) go up.
So it’s important to compare the price you pay for a company’s stock to the earnings that you and other investors expect that company to make in the future. That’s especially important now, when investors seem to be paying sky-high prices for possibly unattainable earnings.
Internet stocks in particular seem to have lost all connection with reality. Some are 100 times minuscule earnings as investors simply bet that some day some kind of business will emerge. America Online’s price is more than 300 times this year’s earnings.
According to a recent study, done for Fidelity Investment by the Yankelovich Group, two-thirds of investors don’t realize that stock prices are tied to company earnings growth. They think that if investors continue to love stocks, prices will simply continue to go up. And, to some extent, that mindless affection has worked.
But investment experts say that it can’t last.
What’s been happening “is a bit disconcerting–in fact, downright scary,” says Jeremy Siegel, of the University of Pennsylvania’s Wharton School. “As soon as you think stocks are going to keep going up because they go up, and there is no relationship to fundamental factors, that will bite you.”
When you pay for a stock, what you are doing basically is paying for a stream of a company’s future earnings.
If a company starts having trouble selling a product or has to lower the price it charges for the product or encounters higher expenses producing the product, the stream of profits you expected might dry up or slow to a trickle. And the stock price will fall, possibly never to return again to what you paid.
So when you buy a stock, you need to be aware of the quality of profits you expect a company to produce, and compare that to the stock price.
You calculate the price/earnings ratio by dividing the company’s stock price by earnings per share.
Then you look at the relationship of the numbers for guidance, checking on how your stock’s P/E compares to the industry and your stock’s outlook.
If a company looks like it’s going to earn $5 a share that year, but next year doesn’t look as if it will increase profits at all, you probably don’t want to pay more than $5 a share for the stock.
None of this is a perfect science. And analysts differ about what an appropriate P/E is for each stock. Take Coca-Cola, with a price at about 47 times its earnings. Many money managers think that’s nuts.
Yet, even with market turmoil overseas hurting Coke’s sales, Warren Buffett continues to hold his Coke stock, claiming it’s a stock he can count on to keep growing sales year after year.
Analysts also cannot agree whether the Standard & Poor’s 500 is overpriced. Over the past several decades, stocks have normally sold for about 15 times their per share earnings. Now the P/E of the Standard & Poor’s 500 is currently at about 25.
“I am getting a bit concerned,” says Siegel.
Yet, he adds, that greater stability in the economy and greater control by the Federal Reserve provide a justification for higher P/Es in this era compared to the past.
So while he’s concerned now, he says he won’t be alarmed unless the P/E goes to 30.
Edward Yardeni, chief economist for Deutsche Bank Research, has used Federal Reserve Chairman Alan Greenspan’s model to determine that the stock market currently is about 11 percent overvalued. “The problem now is that earnings expectations are too high,” he said on his Web site, Yardeni.com.
So what does that mean for the woman I overheard who is happy with her returns and oblivious to earnings?
It could mean some losses if she’s invested in a mutual fund, such as an index fund, that reflects the returns of the Standard & Poor’s 500. On the other hand, if someone has been picking her stocks and asking whether the quality of the earnings justifies the stock price, she might continue to be satisfied with her returns.
It could all depend on how harshly the market corrects when earnings, rather than high hopes, rule stock prices.
