VALUATION
Robert O. Welk RowTek Economics
In the
final analysis, the price of a stock must be tied to the ability of the
company to generate profit. In our economic system, the success
of a business enterprise is measured by its profitability. The price of a stock, and the company's earnings, are directly linked. The
most commonly used measure of valuation is the price/earnings ratio.The ratio may be thought of as the number of years before cumulative
current earnings match the price. The reciprocal of the ratio may be thought of as percentage return. The following chart plots the P/E
ratio of the S&P 500 beginning with 1983. Over a very long time interval, i.e., since W.W.II, the historical average has been between 12 -15.
The chart shows that an upward trend was underway for about two decades. There are many reasons given for the uptrend. Studies have shown that the risk premium for equities over fixed income securities is lower than thought earlier. Globalization has reduced the probability of intervals of rapid inflation, or severe swings in the business cycle. I believe that supply and demand for equities is also important in causing the rise. The advice to diversify investments, and the argument that equities are the best way to share in the growth of the economy, have been widely accepted. Furthermore, the popularity of 401k and other similar plans, on-line investment by individuals, etc. has created demand for equities that has exceeded supply. These reasons, in my view, are valid in expecting valuation measures to be higher than the historical, long-term, average. (If private accounts ever become part of a revised scheme for Social Security the p/e ratio may be pushed even higher.)
The ratio in 1995 was 16.4, a realistic level. Thereafter, however, the
bubble in technology stock prices lifted the measure to an unrealistic and
unsustainable level of 34 in 2001 and 2002. After the collapse in stock prices the p/e became more realistic. The average for 2005 was 19.5, for 2006,18.1 and for 2007, 18.0. On September 30, 2008 the ratio was 22.5, higher because of anemic total earnings, reflecting financial companies losses.
In the current financial panic background, this discussion of the value of the overall P/E ratio has little relevance. As indicated in bearmarket, my view is that stock prices are in a severe decline. At present, the stock market is not a place to be investing funds, except for the person who has a very long time horizon.
END
Copyright © 2008 RowTek Economics. All rights reserved.
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of a business enterprise is measured by its profitability. The price of a stock, and the company's earnings, are directly linked. The
most commonly used measure of valuation is the price/earnings ratio.The ratio may be thought of as the number of years before cumulative
current earnings match the price. The reciprocal of the ratio may be thought of as percentage return. The following chart plots the P/E
ratio of the S&P 500 beginning with 1983. Over a very long time interval, i.e., since W.W.II, the historical average has been between 12 -15.
The chart shows that an upward trend was underway for about two decades. There are many reasons given for the uptrend. Studies have shown that the risk premium for equities over fixed income securities is lower than thought earlier. Globalization has reduced the probability of intervals of rapid inflation, or severe swings in the business cycle. I believe that supply and demand for equities is also important in causing the rise. The advice to diversify investments, and the argument that equities are the best way to share in the growth of the economy, have been widely accepted. Furthermore, the popularity of 401k and other similar plans, on-line investment by individuals, etc. has created demand for equities that has exceeded supply. These reasons, in my view, are valid in expecting valuation measures to be higher than the historical, long-term, average. (If private accounts ever become part of a revised scheme for Social Security the p/e ratio may be pushed even higher.)
The ratio in 1995 was 16.4, a realistic level. Thereafter, however, the
bubble in technology stock prices lifted the measure to an unrealistic and
unsustainable level of 34 in 2001 and 2002. After the collapse in stock prices the p/e became more realistic. The average for 2005 was 19.5, for 2006,18.1 and for 2007, 18.0. On September 30, 2008 the ratio was 22.5, higher because of anemic total earnings, reflecting financial companies losses.
In the current financial panic background, this discussion of the value of the overall P/E ratio has little relevance. As indicated in bearmarket, my view is that stock prices are in a severe decline. At present, the stock market is not a place to be investing funds, except for the person who has a very long time horizon.
END
Copyright © 2008 RowTek Economics. All rights reserved.
BACK TO MAIN PAGE