Use P/E ratio to measure stock value

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

equity investments.

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,

not investing.

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

To read more from Milt Zall (or Bureaucratus), type "Zall" in the search



Stay Connected

FCW Update

Sign up for our newsletter.

I agree to this site's Privacy Policy.