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
  stocks 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.

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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
• Firms capital structure i.e. required rate of
  return
• Current and expected Inflation
• Level of dividends, expected dividend payout

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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.

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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

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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.

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What P/E Will the Stock Market Support? C. Barry
White (FAJ, Nov/Dec2000)

• 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 SP about 18
• 1973-74-Large cap stock as a group lost 37 P/E
  fell to 7.

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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.

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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.

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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 SP 500

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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.

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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/P4.73
• 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.

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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 (

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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)(1g)
• K-g
• Thus
• P/E positively related to payout
• Volatility of return increases, so does K, this
  lowers P/E

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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.

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What P/E Will the Stock Market Support?

• Reilly, Griggs, and Wong (1983) 1962-80 SP 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.

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What P/E Will the Stock Market Support?

• White (1997) Data from 1956-95 for SP 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 (-)

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What P/E Will the Stock Market Support?

• Kane, Marcus and Noh (1996) Monthly data for SP
  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.

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What P/E Will the Stock Market Support?

• Loughlin (1996) Quarterly data for 1968-93, SP
  500
• Dividend payout ()
• Five year T-notes (-)
• Expected Earnings ()

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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.

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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-statetc.
• Explain the model building process.

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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

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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.

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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?

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