Use P/E ratio to measure stock value
- By Milt x_Zall
- Feb 24, 2000
With the price-to-earnings ratio (P/E) for the Standard and Poor's 500 index
at an all-time high, can the market continue climbing or are we in for a
major correction? That debate has been going on for the past five years
as the current bull market surged and the doom-and-gloom crowd missed out
on some really big money.
Conventional wisdom says that a low P/E ratio is good and a high P/E
ratio is dangerous. But in today's market, what is a high P/E ratio and
what is a low P/E ratio?
In the current the interest rate environment, conventional yardsticks
are not very helpful. Long-term interest rates are relatively low, making
it easier for companies to finance expansions and increase their profits.
How much a stock is worth depends on the demand for that stock and the available
supply. With long-term interest rates below 7 percent, those who might otherwise
be attracted to government and corporate bonds instead are looking for attractive
Why? Because a return of less than 7 percent is not very attractive.
Would-be bond investors are bidding up the price of stocks. Where else should
they put their money? Gold? Gold is selling for about $300 an ounce. In
1980, it sold for $850 an ounce. Real estate? Ever since the passage of
the 1986 tax reform act that altered the rules governing depreciation, real
estate has been in the doldrums.
The absence of competing investment opportunities is pushing up the
price of stocks. In addition, the Federal Reserve has been aggressive toward
inflation and seems to be keeping it in check through a gradual increase
in interest rates. A low-inflation environment is good for business. When
inflation and interest rates are low, companies can borrow funds to expand
their operations at attractive rates without fear of being unable to repay
their loans. In such an environment, companies are willing to take more
chances. And the results speak for themselves. We are enjoying an unparalleled
era of prosperity: low inflation, low interest rates and low unemployment
coupled with higher productivity.
How do you decide what is a good price for a stock in today's environment?
Look at a company's long-term growth rate. If a company is growing at 25
percent per year, a P/E ratio of 25 is a steal.
Average a company's growth rate over the past five years. Using that
figure as a starting point, multiply that number by 1.5. You should not
pay more for a stock (in terms of its P/E ratio), than one and one half
times a company's long-term growth rate. The closer the long-term growth
rate is to the P/E ratio, the better I like it.
Other pundits are willing to pay far more than that, but I believe that
this approach is safer. If a company is growing at an average rate of 15
percent a year, buying the stock at a P/E ratio of 30 (twice its growth
rate) may not make any sense. The only way that might make sense is if the
company's growth is accelerating — if, for example, it grew at a 30 percent
clip last year and prospects for this year look even better. You have to
pay a reasonable price for the stocks you buy. Otherwise, you are speculating,
The price you pay for a stock should reflect its future prospects and
past performance. In January 1998, the S&P 500 was selling at a P/E
multiple of 24.1. A year earlier, it was 20.2. At that time, according to
data compiled by Bloomberg Financial News, analysts were projecting a 16.3
P/E multiple for the 1999 S&P 500. Clearly, the analysts were wrong.
Today, these same analysts are projecting a 26 P/E ratio for the S&P
500 one yea
Stocks just cannot keep going up and up. The price of stocks
must reflect their intrinsic value. A year ago, investors were willing to
pay a high P/E multiple for the S&P 500 because they believed that the
P/E multiple a year later would decline as a result of improved earnings.
Well, earnings did improve, but stock prices rose out of proportion to the
earnings increases. This cannot go on indefinitely. If earnings do not accelerate
significantly during the next year, do not expect the S&P 500 to rise.
We will be lucky if it does not decline s
—Zall is a free-lance writer based in Silver Spring, Md., who specializes
in taxes, investing and business issues. He is a certified internal auditor
and a registered investment adviser. He can be reached via e-mail at firstname.lastname@example.org.
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