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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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One very common way to interpret the P/E ratio is as a measure of investorsFat Stocks, Fat People, and P/E You get what you pay for. As noted, fundamentalists believe that this maxim extends to stock valuation. They argue that a companys stock is worth only what it returns to its holder in dividends and price increases. To determine what that value is, they try to make reasonable estimates of the amount of cash the stock will generate over its lifetime, and then they discount this stream of payments to the present. And how do they estimate these dividends and stock price increases? Value investors tend to use the companys stream of earnings as a reasonable substitute for the stream of dividends paid to them since, the reasoning goes, the earnings are, or eventually will be, paid out in dividends. In the meantime, earnings may be used to grow the company or retire debt, which also increases the companys value. If the earnings of the company are good and promise to get better, and if the economy is growing and interest rates stay low, then high earnings justify paying a lot for a stock. And if not, not. Thus we have a shortcut for determining a reasonable price for a stock that avoids complicated estimations and calculations: the stocks so-called PIE ratio. You cant look at the business section of a newspaper or watch a business show on TV without hearing constant references to it. The ratio is just that-a ratio or fraction. Its determined by dividing the price P of a share of the companys stock by the companys earnings per share E (usually over the past year). Stock analysts discuss countless ratios, but the P/E ratio, sometimes called simply the multiple, is the most common. The share price, P, is discovered simply by looking in a newspaper or online, and the earnings per share, E, is obtained by taking the companys total earnings over the past year and dividing it by the number of shares outstanding. (Unfortunately, earnings are not nearly as cut-and-dried as many once thought. All sorts of dodges, equivocations, and outright lies make it a rather plastic notion.) So how does one use this information? One very common way to interpret the P/E ratio is as a measure of investors expectations of future earnings. A high PIE indicates high expectations about the companys future earnings, and a low one low expectations. A second way to think of the ratio is simply as the price you must pay to receive (indirectly via dividends and price appreciation) the companys earnings. The P/E ratio is thus both a sort of prediction and an appraisal of the company. A company with a high P/E must perform to maintain its high ratio. If its earnings dont continue to grow, its price will decline. Consider Microsoft, whose P/E was somewhere north of 100 a few years ago. Today its P/E is under 50, although its one of the larger companies in Redmond, Washington. Still a goliath, its nevertheless growing more slowly than it did in its early days. This shrinking of the P/E ratio occurs naturally as start-ups become blue-chip pillars of the business community. (The pattern of change in a companys growth rate brings to mind a mathematical curve-the S-shaped or logistic curve. This curve seems to characterize a wide variety of phenomena, including the demand for new items of all sorts. Its shape can most easily be explained by imagining a few bacteria in a petri dish. At first the number of bacteria will increase slowly, then at a more rapid exponential rate because of the rich nutrient broth and the ample space in which to expand. Gradually, however, as the bacteria crowd each other, their rate of increase slows and their number stabilizes, at least until the dish is enlarged. The curve appears to describe the growth of entities as disparate as a composers symphony production, the rise of airline traffic, highway construction, mainframe computer installations, television ownership, even the building of Gothic cathedrals. Some have speculated that there is a kind of universal principle governing many natural and human phenomena, including the growth of successful businesses.) Of course, the P/E ratio by itself does not prove anything. A high P/E does not necessarily indicate that a stock is overvalued (too expensive for the cash flow its likely to generate) and a candidate for selling, nor does a low one indicate that a stock is undervalued and a candidate for buying. A low P/E might mean that a company is in financial hot water despite its earnings. As WorldCom approached bankruptcy, for example, it had an extremely low P/E ratio. A constant stream of postings in the chatrooms compared it to the P/Es of SBC, AT&T, Deutsche Telekom, Bell South, Verizon, and other comparable companies, which were considerably higher. The stridency of the postings increased when they failed to have their desired effect: Investors hitting their foreheads with the sudden realization that WCOM was a great buy. The posters did have a point, however. One should compare a companys P/E to its value in the past, to that of similar companies, and to the ratios for the sector and the market as a whole. The average P/E for the entire market ranges somewhere between 15 and 25, although there are difficulties with computing such an average. Companies that are losing money, for example, have negative P/Es although theyre generally not reported as such; they probably should be. Despite the recent market sell-offs in 2001-2002, some analysts believe that stocks are still too expensive for the cash flow theyre likely to generate. Like other tools that fundamental analysts employ, the P/E ratio seems to be precise, objective, and quasi-mathematical. But, as noted, it too is subject to events in the economy as a whole, strong economies generally supporting higher P/Es. As bears reiteration (verb appropriate), the P in the numerator is not invulnerable to psychological factors nor is the E in the denominator invulnerable to accountants creativity. The P/E ratio does provide a better measure of a companys financial health than does stock price alone, just as,for example, the BMI or body mass index (equal to your weight divided by the square of your height in appropriate units) gives a better measure of somatic health than does weight alone. The BMI also suggests other ratios, such as the P/E2 or, in general, the P/Ex, whose study might exercise analysts to such a degree that their BMIs would fall. (The parallel between diet and investment regimens is not that far-fetched. There are a bewildering variety of diets and market strategies, and with discipline you can lose weight or make money on most of them. You can diet or invest on your own or pay a counselor who charges a fee and offers no guarantee. Whether the diet or strategy is optimal or not is another matter, as is whether the theory behind the diet or strategy makes sense. Does the diet result in faster, more easily sustained weight loss than the conventional counsel of more exercise and a smaller but balanced intake? Does the market strategy make any excess returns, over and above what you would earn with a blind index fund? Unfortunately, most Americans waistlines in recent years have been expanding, while their portfolios have been getting slimmer. Numerical comparisons of the American economy to the world economy are common, but comparisons of our collective weight to that of others are usually just anecdotal. Although we constitute a bit under 5 percent of the worlds population, we make up, I suspect, a significantly greater percentage of the worlds human biomass.) There is one refinement of the PIE ratio that some find very helpful. Its called the PEG ratio and it is the P/E ratio divided by (100 times) the expected annual growth rate of earnings. A low PEG is usually taken to mean that the stock is undervalued, since the growth rate of earnings is high relative to the P/E. High P/E ratios are fine if the rate of growth of the company is sufficiently rapid. A high-tech company with a P/E ratio of 80 and annual growth of 40 percent will have a PEG of 2 and may sound promising, but a stodgier manufacturing company with a P/E of 7 and an earnings growth rate of 14 percent will have a more attractive PEG of .5. (Once again, negative values are excluded.) Some investors, including the Motley Fool and Peter Lynch, recommend buying stocks with a PEG of .5 or lower and selling stocks with PEG of 1.50 or higher, although with a number of exceptions. Of course, finding stocks having such a low PEG is no easy task. Contrarian Investing and the Sports Illustrated Cover Jinx As with technical analysis, the question arises: Does it work? Does using the ideas of fundamental analysis enable you to do better than you would by investing in a broad-gauged index fund? Do stocks deemed undervalued by value investors constitute an exception to the efficiency of the markets? (Note that the term undervalued itself contests the efficient market hypothesis, which maintains that all stocks are always valued just right.) The evidence in favor of fundamental analysis is a bit more compelling than that supporting technical analysis. Value investing does seem to yield moderately better rates of return. A number of studies have suggested, for example, that stocks with low P/E ratios (undervalued, that is) yield better returns than do those with high P/E ratios, the effects strength varying with the type and size of the company. The notion of risk, discussed in chapter 6, complicates the issue. Value investing is frequently contrasted with growth investing, the chasing of fast-growing companies with high P/Es. It brings better returns, according to some of its supporters, because it benefits from investors overreactions. Investors sign on too quickly to the hype surrounding fast-growing companies and underestimate the prospects of solid, if humdrum companies of the type that Warren Buffett likes-Coca-Cola, for instance. (I write this in a study littered with empty cans of Diet Coke.) The appeal of value investing tends to be contrarian, and many of the strategies derived from fundamental analysis ref l ect this. The dogs of the Dow strategy counsels investors to buy the ten Dow stocks (among the thirty stocks that go into the Dow-Jones Industrial Average) whose price-todividend, P/D, ratios are the lowest. Dividends are not earnings, but the strategy corresponds very loosely to buying the ten stocks with the lowest P/E ratios. Since the companies are established organizations, the thinking goes, theyre unlikely to go bankrupt and thus their relatively poor performance probably indicates that theyre temporarily undervalued. This strategy, again similar to one promoted by the Motley Fool, became popular in the late 80s and early 90s and did result in greater gains than those achieved by, say, the broad-gauged S&P 500 average. As with all such strategies, however, the increased returns tended to shrink as more people adopted it. A ratio that seems to be more strongly related to increased returns than price-to-dividends or price-to-earnings is the price-to-book ratio, P/B. The denominator B is the companys book value per share-its total assets minus the sum of total liabilities and intangible assets. The P/B ratio changes less over time than does the P/E ratio and has the further virtue of almost always being positive. Book value is meant to capture something basic about a company, but like earnings it can be a rather malleable number. Nevertheless, a well-known and influential study by the economists Eugene Fama and Ken French has shown P/B to be a useful diagnostic device. The authors focused on the period from 1963 to 1990 and divided almost all the stocks on the New York Stock Exchange and the Nasdaq into ten groups: the 10 percent of the companies with the highest P/B ratios, the 10 percent with the next highest, on down to the 10 percent with the lowest P/B ratios. (These divisions are called deciles.) Once again a contrarian strategy achieved better than average rates of return. Without exception, every decile with lower P/B ratios outperformed the deciles with higher P/B ratios. The decile with lowest P/B ratios had an average return of 21.4 percent versus 8 percent for the decile with the highest P/B ratios. Other studies findings have been similar, although less pronounced. Some economists, notably James OShaughnessy, claim that a low price to sales ratio, P/S, is an even stronger predictor of better-than-average returns. Concern with the fundamental ratios of a company is not new. Finance icons Benjamin Graham and David Dodd, in their canonical 1934 text Security Analysis, stressed the importance of low P/E and P/B ratios in selecting stocks to buy. Some even stipulate that low ratios constitute the definition of value stocks and that high ratios define growth stocks. There are more nuanced definitions, but there is a consensus that value stocks typically include most of those in oil, finance, utilities, and manufacturing, while growth stocks typically include most of those in computers, telecommunications, pharmaceuticals, and high technology. Foreign markets seem to deliver value investors the same excessive returns. Studies that divide a countrys stocks into fifths according to the value of their P/E and P/B ratios, for example, have generally found that companies with low ratios had higher returns than those with high ratios. Once again, over the next few years, the undervalued, unpopular stocks performed better. There are other sorts of contrarian anomalies. Richard Thaler and Werner DeBondt examined the thirty-five stocks on the New York Stock Exchange with the highest rates of returns and the thirty-five with the lowest rates for each year from the 1930s until the 1970s. Three to five years later, thebest performers had average returns lower than those of the NYSE, while the worst performers had averages considerably higher than the index. Andrew Lo and Craig MacKinlay,as mentioned earlier, came to similar contrarian conclusions more recently, but theirs were significantly weaker, reflecting perhaps the increasing popularity and hence decreasing effectiveness of contrarian strategies. Another result with a contrarian feel derives from management guru Tom Peterss book In Search of Excellence, in which he deemed a number of companies excellent based on various fundamental measures and ratios. Using these same measures a few years after Peterss book, Michelle Clayman compiled a list of execrable companies (my word, not hers) and compared the fates of the two groups of companies. Once again there was a regression to the mean, with the execrable companies doing considerably better than the excellent ones five years after being so designated. All these contrarian findings underline the psychological importance of a phenomenon Ive only briefly mentioned: regression to the mean. Is the decline of Peterss excellent companies, or of other companies with good P/E and P/B ratios the business analogue of the Sports Illustrated cover jinx? For those who dont follow sports (a field of endeavor where the numbers are usually more trustworthy than in business), a black cat stared out from the cover of the January 2002 issue of Sports Illustrated signaling that the lead article was about the magazines infamous cover jinx. Many fans swear that getting on the cover of the magazine is a prelude to a fall from grace, and much of the article detailed instances of an athletes or a teams sudden decline after appearing on the cover. There were reports that St. Louis Rams quarterback Kurt Warner turned down an offer to pose with the black cat on the issues cover. He wears No. 13 on his back, so maybe theres a limit to how much bad luck he can withstand. Besides, a couple of weeks after gracing the cover in October 2000, Warner broke his little finger and was sidelined for five games. The sheer number of cases of less than stellar performance or worse following a cover appearance is impressive at first. The author of the jinx story, Alexander Wolff, directed a team of researchers who examined almost all of the magazines nearly 2,500 covers dating back to the first one, featuring Milwaukee Braves third baseman Eddie Mathews in August 1954. Mathews was injured shortly after that. In October 1982, Penn State was unbeaten and the cover featured its quarterback, Todd Blackledge. The next week Blackledge threw four interceptions against Alabama and Penn State lost big. The jinx struck Barry Bonds in late May 1993, seeming to knock him into a dry spell that reduced his batting average forty points in just two weeks. |
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