Taking stock

There's been an explosion of contradictory articles about the U.S. stock market recently. I'd like to focus on what's been said about price/earnings (p/e) ratios in particular. Some sources (the bears) say the p/e ratios are too high, while others (the bulls) say they've got plenty of room to grow. What gives? Let's start with the premise that stock prices should be related to company earnings. It's

There's been an explosion of contradictory articles about the U.S. stock market recently. I'd like to focus on what's been said about price/earnings (p/e) ratios in particular. Some sources (the bears) say the p/e ratios are too high, while others (the bulls) say they've got plenty of room to grow. What gives?

Let's start with the premise that stock prices should be related to company earnings. It's important to remember that because of inflation, a dollar today is worth more than a dollar tomorrow.

The price of a particular stock is determined by how long an investor plans to hold onto the stock, as well as the interest rate used to “discount” the company's future earnings. By this we're referring to the fact that investors have to decide whether they'll make more by investing in the stock or by putting that money into something else (bonds, real estate, money market, etc). Interest rates play a big role in this decision. If rates are high, stocks look less attractive than some other investments; if they're low, stocks may be a good investment.

Let's assume there's a formula that will enable us to determine the expected earnings flow of a company over time. The result is a stream of future earnings that helps us decide how much we're willing to pay for the stock today. This is referred to as the “present value” of the income stream. Here's another way to look at it. You're thinking of buying stock in a company and holding onto it for 10 years. You then estimate what kind of return on your investment — based on the company's future income stream — you expect to get over the next 10 years. Now you have to decide how much you're willing to pay for that stock today.

Although it might seem that everyone — the bulls and the bears — should agree on the income stream for a particular stock, they don't. Determining the present value of a company's stock involves some guesswork, especially in the way a discount rate is determined.

Several factors determine the discount rate. The first is the expected rate of inflation. What we think is going to happen to inflation rates in the future affects the value we assign future company earnings. If we expect rates to be high, the current value of an income stream will be lower than if we expect inflation to be low.

The second element relates to the degree of uncertainty in the economy. Just three or four years ago, uncertainty was minimal, with the sky seemingly the limit in terms of the stock market. People were willing to pay almost anything for a stock. They weren't looking for exceptionally high rates of return as a hedge against a future downturn because they didn't think a downturn in the near future was even a possibility. When things are good we're willing to settle for a lower rate of return. For a specific company, this translates into a smaller discount factor, which means the current value of the future earnings will be higher.

The third element affecting a company's discount rate is how risky we consider its industry. Determining a risk level involves comparing earning patterns to those in other industries. Companies in industries that tend to have ups and downs would have higher discount rates than those that are steadier. When businesses are cyclical, it's harder to predict future earnings.

So why are p/e ratios so much higher now than they've been in the past? The S&P trailing one-year p/e ratio is almost 26, while the 75-year average is only 14. Could it be that we expect lower inflation rates than we've had in the past? Yes, it could. Could it be that we expect smaller economic downturns? Yes, it could. Are we over-valued at 26? Unfortunately for investors, we don't really know.

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