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Understanding Price

Understanding Price

Has the market’s enthusiasm eroded all the safety out of buying stocks? In fact, for a few weeks now I have been saying that there are very few quality stocks that are cheap.

We appear to be in a good old-fashioned asset boom. I cannot see how it will all end nor when, but experience tells me that it is time for cautious optimism at best and nervous caution at worst. 

The poor underlying earnings growth does not justify the rich prices attributed to stocks in Australia, and highly priced US stocks are equally precarious after a seven-year economic expansion that appears to now have the wobbles, and despite trillions in stimulus.

Many analysts are using the high price to earnings (P/E) ratios to justify their arguments that the market is expensive.  But if you don’t already know, I have no use for P/E ratios. Let me explain why.

Suppose three companies each have $10 of equity per share, each returns 20 percent on that equity and each is trading on a P/E of 10, which equates to $20. The only difference is that the first company is paying out 100 percent of its earnings as a dividend, the second is paying out 50 percent and the third is paying no dividends. If you were to assume that you could buy and sell the shares at the same P/E of ten times, the first company would return 10 percent per annum over any number of years, the second would return 15 percent and third will return 20 percent per annum. The third is clearly the cheapest and yet all three had the same P/E of 10. P/E’s can’t tell you very much about whether stocks are cheap or expensive other than in the most crude and rudimentary way.

There are however times when P/E’s are at such extremes that they provide support to my preferred analysis of the spread between price and value. Now may or may not be one of those times.

In October 2009 it was suggested by many economists that the US economy was emerging from recession.  September 2009 was the last month of the recession and the trailing P/E was 27 times. This seemed extreme at the time and out of nine recessions since 1954, it represented the highest trailing P/E at the last month of a recession, with the exception of November 2001.

Despite those expensive ‘valuations’ the US S&P500 has more than doubled and individual issues such as AAPL are up fivefold.

Many of you will correctly point out that it makes no sense to use trailing P/E’s when emerging from a recession because the trailing ‘E’ is unusually low. In such situations, analysts focus on forward P/E’s. (Of course you know my view; if P/E’s are nonsense, then forward P/E’s, sector average P/E’s and the like are simply nonsense cubed).

Whether emerging from a recession, such as in the US in 2009 or perhaps falling back into one today, the P/E ratio must be used with care as a guide to whether stocks are cheap or expensive. 

For those who must now we believe the one year forward P/E in Australia excluding energy and resource stocks is close to 19 times.  That’s the highest it has been since 1990 with the exception of the booms prior to the recession we had to have and the tech wreck.

But while it seems that multiples have, surged from historic lows to near all-time highs, and while conventional wisdom would suggest that P/E’s are at levels normally reserved for the late stages of a bull market, there is a counter argument; at market peaks, such as October 2007, analysts are unusually bullish about the future, while after a recession analysts will be overly cautious about their forecasts. The result is low relative forward P/E’s at peaks.

And yet, today, there is precious little optimism about Australian corporate earnings.  Indeed on Montgomery analysis, while the Australian stock market price has rallied only a meager 24% in total over five years, earnings growth has been a far worse, growing just 5.47% in aggregate over the same period.  In other words, most of the stock market’s growth has simply come from a willingness on the part of investors to pay more.  No wonder there is little optimism.

P/E ratios are a function of price and prices are freely available, an information-free zone.  Perhaps their only use then is to track sentiment – that willingness to pay more and something notoriously unpredictable.

And what about the question of whether the market is expensive or cheap?  Our analysis suggests the market is overpriced by about 10%.  But before you conclude the market is due for an imminent correction, keep in mind that it has been much more expensive in the past and periods of overpricing have lasted much longer than the current phase.

 
Roger Montgomery
Roger Montgomery

Roger shares his stock market insights at his Insights blog, blog.rogermontogmery.com. Investors can also follow Roger on Facebook and watch media interviews at his YouTube channel. Grab your Second Edition copy of Value.able and learn how Roger Montgomery values the best stocks and buys them for less than they're worth. Grab the book now at special price!