Despite the abundance of complicated investing strategies, stock market success is simple. You have to sell a stock for more than you paid.
The hard part is knowing whether a stock trades for more or less than it is worth. To measure that, many investors turn to a stock’s price-to-earnings ratio, or P-E.
These numbers are bandied about in financial news as if everyone agrees on their significance. But there’s no consensus on how to interpret P-Es or even on what they mean.
“The price-to-earnings ratio — that’s for amateurs,” said Martin Whitman, manager of Third Avenue Value Fund.
“They are a fundamental yardstick of valuations,” countered Jeremy Siegel, the University of Pennsylvania Wharton School professor who wrote “Stocks for the Long Run.” “That’s what is left to the shareholder after all the company’s expenses — interest payments, employee costs.”
The P-E is calculated by dividing a stock’s price by its yearly per-share earnings. A stock that sells for $50 per share that generated $2 in earnings would have a P-E of 25.
It’s a measure of value. A stock is worth only as much as its future earnings. The P-E ratio expresses how much an investor is willing to pay today for $1 worth of future earnings. Because money received in the future is worth less than money received today (you would rather have $100 now than five years from now, right?), today’s stock price is reduced to reflect the fact that investors will not see the earnings until a later date.
P-Es are a place to start in evaluating a stock.
“It’s one of the easiest valuation measures for folks to learn, track and understand,” said Charles Crane, market strategist at Spears, Benzak, Salomon & Farrell Inc., which manages $5 billion in New York. “The P-E ratio is a measure of what the market is currently paying for that company’s existing stream of earnings.”
Some investment professionals think P-Es are less relevant than other measures. Others find them useless because investor psychology, and not earnings, can create market manias or depressions. Still others complain that interpreting the number requires reams of other data.
Finally, some analysts prefer to use a variant of the P-E known as the price-to-cash-flow ratio. Cash flow is the amount of cash that comes in the door minus the amount that flows out.
“Cash flow is cash flow,” Crane said. “You can’t mask it. It’s how many beans are left in the pot at the end of the day.”
Traditionally, value managers have made money by buying low P-E stocks: those that sell for 10 or less. Whitman, however, thinks an overemphasis on P-E ratios can cause investors to miss opportunities. His fund is a top performer among those that focus on small, value-oriented stocks.
“The fact is that earnings do drive some stock market prices, but in other cases factors other than earnings are much more important,” he said. For example, stocks can appreciate if a company reorganizes successfully, sells assets or can access capital inexpensively, as happened with many technology companies that went public last year, he said.
With companies whose value is based more on how much its corporate assets are worth than on earnings, price-to-book ratios might offer more insight, some analysts said. A price-to-book ratio is the stock price divided by per-share book value. Book value is net worth, or assets minus liabilities.
Buying stocks by the numbers, of course, is a rational person’s approach. Plenty of people buy stocks simply because they are going up or sell them because they are going down. What else explains rockets that crashed to earth such as Boston Chicken Inc. and drkoop.com Inc.?
In hindsight, hype built those stocks, but not every high P-E stock is a clear case of investor mania. Cisco Systems Inc., for example, trades at 122 times the last year’s earnings and 88 times estimated earnings.
Clearly, Cisco is a successful company that sells computer networking products that are necessities at most companies, not fads. Its earnings have grown, on average, at 30 percent yearly for the last five.
Does that mean it deserves such a rich P-E?
Many experts still recommend Cisco, but others doubt that any company can live up to the lofty expectations built into that price.
That’s the pessimist’s view.
Don your rose-colored glasses, and you can argue that if Cisco continues to increase earnings at 30 percent yearly, and investors continue to pay a big premium for that growth, the stock could enrich many more people.
Which view is right?
Siegel, for one, thinks many of the big technology stocks, such as Cisco, are overvalued.
“Stocks are kind of like wines,” he said. “There are really cheap wines that you know you can pay $6 or $7 a bottle for, or even less, and then there are those that cost $50, $60, $160 per bottle. They taste better. The same is true of stocks.
“Cisco’s potential for earnings growth in the future, I think it would generally be agreed, is better than for General Motors or Ford. The question is how much more should we pay? … We’ve sort of had an unprecedented escalation in the price of these really good stocks.”
The high valuations awarded to many stocks today remind people of the early 1970s, when stocks such as Xerox Corp. traded at 46 times earnings. On average, stocks have traded at P-Es in the mid- to low teens.
Xerox has disappointed shareholders since then. Today, it trades for 11 times earnings from continuing operations.
P-Es can also raise questions because analysts use different numbers for the denominator, earnings. In Xerox’s case, continuing earnings — profits from ongoing operations — are more relevant because the company has gone through several reorganizations. Many analysts also prefer to consider estimated earnings rather than historically reported, because estimated represents a company’s prospects.
The low P-E at Xerox might bring bargain-hunters sniffing, but a P-E that’s in the basement might be there for a reason.
“The low P-E companies are the lousy companies in corporate America,” said Chris Darnell, chief investment officer at Grantham, Mayo, Van Otterloo & Co., the Boston money manager who runs Vanguard U.S. Value Fund. “They should sell at a discount, and they always do. Unfortunately, many value investors think that if they’re at a discount, they’re always a good buy.”
That method only works when beaten-up stocks sell at steeper-than-usual discounts to the overall market, Darnell said. One of those periods is now, Darnell said, which might make carefully chosen low P-E stocks a good bet.
In fact, a stock’s P-E sheds the most light when it is considered along with other information, such as how prices on value stocks compare with those on stocks overall.
Cisco, for example, looks expensive until you consider its competitor, Juniper Networks Inc. That company trades at more than 600 times estimated earnings.
That could be a sign that Cisco is in such a high-growth industry that its P-E makes sense. Or it could mean that Juniper is the next Cisco. Or that the market is simply overvaluing these computer networking companies.
