Thoughts on the P/E Ratio

September 8, 2010

TBP has a good post up on P/E Expansion & Contraction featuring a helpful chart from Crestmont Research.

My discussion comment is below — you can also click on the chart thumbnail for the full-sized version.

I like the wisdom of Dickson G. Watts here:

“Learn principles. Facts will then fall into their relations and connections.”

Long-term investors tend to think of a stock as a discounted stream of future cash flows.

And so the P/E ratio is, essentially, a measure of how much investors are willing to pay for that discounted future cash flow in a business they want to own (with a good helping of uncertainty, or ‘risk premium’, on top).

From this perspective a P/E ratio isn’t “good” or “bad” or even a standalone indicator of any great merit, so much as a rough proxy for what investors are willing to pay, with all the other stuff — uncertainty, opportunity cost, credit availability, risk appetite — factored in.

So what the Crestmont chart is really saying, when you take a step back, is not that bull and bear markets are driven by P/E ratios per se, but rather that 1) as a basic measure of how much investors are willing to pay, the P/E ratio simply and clearly reflects whether investors are feeling tight-fisted or generous, and new bull or bear markets tend to begin after the pendulum has swung to an extreme.

For a real bear market to get underway, then, assets have to be expensive (in terms of what investors are willing to pay for discounted future cash flows). For a real bull market to begin, in contrast, assets have to be cheap on a discounted cash flow basis.

The nice thing with getting down to the nitty gritty is that, once one has the principles in place, facts fall into “relations and connections” as Watts suggested. There is less need to rely on complicated cycle theories or wonky overlays.

My .02 is that the hemming and hawing over the P/E ratio now comes from a bunch of partisan observers who don’t like the implied message that markets are sending, which is rooted in one simple observation:

An economy that is historically driven by 70% consumer spending is going to be in a world of hurt when, after a 25 year leverage and debt binge, consumers have been box-canyoned into an involuntary forced savings program at the same time middle class jobs are disappearing, housing is cratering, and government efforts to “help” are both crowding out private investment opportunities and strangling the historical job producing areas of the economy with legislation and red tape.


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2 Responses to Thoughts on the P/E Ratio

  1. Ed618 on September 9, 2010 at 12:41 pm

    I believe that analyzing long-term PE charts has an inherent problem.

    Financial accounting has evolved tremendously in the last century. Of course, the desire has been to show greater earnings, in light of the ever-growing scrutiny from analysts, investors, and the public in general. So I believe that over time, changes in accounting methods will yield an upward sloping PE curve even with constant earnings.

    I'd love to see a comparison of old financial results translated to today using current GAAP, but it's a little too involved for me. Any PHD candidates looking for a thesis?

    • Jack Sparrow on September 9, 2010 at 12:58 pm

      Interesting (and potentially quite valid) point… on the other hand, though, the Wall Street sales machine has a direct incentive to consistently tamp down the P/E Ratio for the sake of making stocks look "cheap," and a trend towards higher reported earnings would imply more reasonable valuations.

      There are subtleties here — as will there be in ANY estimation of future cash flows, which are impacted by all manner of things — and market participants ignore non-linear inputs at their own risk.

      p.s. John Hussman has some top notch commentary on the travesty of "forward operating earnings:"

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