Low P/E ratios could make it difficult to borrow the money needed for future growth
The future of trucking is currently reflected in the value of industry stocks -- and the news is not good. Since trucking in general is not viewed as a fast-growing segment, investors are assigning P/E ratios that are well below the market average.
Before we talk about what we can do about this, let's look at how stock values are determined in the first place. One of the most important factors in this process is the discount rate that is assigned to a particular stock. A discount rate is really a desired rate of return on an investment. For example, you might be willing to settle for a low rate of return if an investment is considered relatively safe. But if the investment is considered risky, you will want a higher rate of return in exchange for taking the risk. Unfortunately, the current market has placed trucking in the latter category, so discount rates are high.
Three primary factors combine to determine these rates: fluctuations in the overall economy, fluctuations in the industry's growth rate, and fluctuations in company earnings.
When you apply this rate to future earnings expectations, you determine the expected market value of the company's stock. If prices rise above that level, people will sell the stock. When they dip below it, people will buy.
Investors usually look at the P/E ratio (price of the stock divided by the earnings per share) when deciding whether or not to buy a stock. If the P/E is 10, for example, an investor is willing to pay 10 times earnings for a share of stock.
With some industry exceptions, trucking among them, P/E ratios in the current market are elevated because people feel good about the future of the economy and corporate earnings.
During the past decade, enormous investments have been made in many industries to improve productivity -- because of the need to survive in a very competitive world and a decline in investment costs. Merger-and-acquisition activity has also been strong, leading to gains in market share for the expanded firms and a broader distribution of fixed expenses to reduce marginal costs.
Increased stability in an industry means less uncertainty about the swings in potential earnings. This reduction in risk leads to a reduction in the risk premium, which in turn increases the present value of future earnings for that industry.
The final level of risk depends upon the valuation of the individual company. This risk is determined by looking at the financial statements of the firm over time. Exposure to debt, ability to gain market share, product development cycles, and management team are all taken into account by investment analysts.
What is troubling to trucking is the fact that we continue to have much lower P/E ratios than the market in general. Very few firms supporting the trucking industry have P/E ratios higher than 10, while the market average for the major stocks is over 20.
Since the overall economic outlook is the same for everyone, the problem must lie within the industry itself. It doesn't appear to be company-specific, since P/E ratios for trucking firms are in the same range.
This is especially disturbing because U.S. banks are under considerable pressure to reassess their outstanding loan portfolios. In addition, while interest rates are currently favorable, we can expect them to rise next year.
As interest rates rise and credit becomes tighter, companies that are considered relatively risky will find it harder and harder to borrow money -- money they need to make product improvements. Suppliers will have to merge in order to reduce overhead per unit of output.
Ironically, our economy could not function without trucking and its equipment suppliers. In addition, demands for equipment have reached record levels during the past decade. Yet investors have apparently decided that our industry, with six decades of performance, is not as good an investment as the genetic engineering startups.