When ‘P’ and ‘E’ Spell Profits

1. 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 stock’s 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.

2. 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 • Firm’s capital structure; i.e. required rate of return • Current and expected Inflation • Level of dividends, expected dividend payout

3. 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.

4. 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

5. 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.

6. 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 S&P about 18 • 1973-74-Large cap stock as a group lost 37%; P/E fell to 7.

7. 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.

8. 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.

9. 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 S&P 500

10. 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.

11. 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/P=4.73% • 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.

12. 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 (<8).

13. 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)(1+g) K-g • Thus: • P/E positively related to payout • Volatility of return increases, so does K, this lowers P/E

14. 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.

15. What P/E Will the Stock Market Support? • Reilly, Griggs, and Wong (1983): 1962-80 S&P 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.

16. What P/E Will the Stock Market Support? • White (1997): Data from 1956-95 for S&P 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 (-)

17. What P/E Will the Stock Market Support? • Kane, Marcus and Noh (1996): Monthly data for S&P 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.

18. What P/E Will the Stock Market Support? Loughlin (1996): Quarterly data for 1968-93, S&P 500 • Dividend payout (+) • Five year T-notes (-) • Expected Earnings (+)

19. 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.

20. 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-stat;etc. • Explain the model building process.

21. 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

22. 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.

23. Independent Variable Expected Variable Inflation Inverse T-bond yields Inverse T-bill yields Inverse Dividend yield on S&P 500 Inverse D/E Direct Money Supply (MZ) Direct FED P/E index Direct Earnings growth Direct Trailing volatility of returns Inverse Trailing S&P 500 returns Direct GDP quarterly growth Direct

24. 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?