Dr. P.V. Viswanath

 

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Is It Time to Scrap the Fusty Old P/E Ratio?

 
 

By Ben Levisohn, WSJ, Sept. 4, 2010

With the vaunted price/earnings ratio losing its mojo as a market gauge, investors are seizing on better ways to value stocks—some of them far removed from corporate earnings statements.

What is wrong with the P/E? In short, the "e" can't be trusted. The Standard & Poor's 500-stock index's average P/E has dropped to 12.3 times earnings based on analyst forecasts for the next four quarters, below the 52-week average of around 14.3.

But "2011 earnings estimates are way too high," says Barry Knapp, head of U.S. equity portfolio strategy at Barclays Capital in New York. That is a problem because investors pay much more attention to earnings forecasts than to past results.

Analysts expect profits to jump 15% next year, according to Thomson Reuters data. But "net revisions" are getting worse. At the beginning of the year analysts boosted their profit forecasts 18% more than they cut them; now the figure is a mere 1%. That is a sign that analysts are becoming more negative and downgrades may be on the way.

For investors trying to gauge the market's value, one alternative may be to discard price and earnings in favor of enterprise value and free cash flow.

Stock price is just one measure of a company's worth. Enterprise value also considers long- and short-term debt, preferred stock, minority interests—in essence a company's entire capital base. By factoring in debt figures, investors can get a better read on whether a company is using leverage to juice its profit results.

Free cash flow, meanwhile, is a broader measure that takes earnings and adds depreciation and amortization while subtracting capital expenditures. It offers a sense of a company's ability to boost dividends, buy back shares or attract suitors.

The enterprise-value-to-free-cash-flow ratio for the S&P 500 is currently 20, a 10-year low.

Savita Subramanian, head of quantitative strategy at Bank of America Merill Lynch in New York, says a strategy of buying the 50 cheapest S&P 500 stocks based on the enterprise-value-to-free-cash-flow ratio has outperformed a similar strategy using forward P/Es by at least 2% since 1986, with less volatility.

An added bonus: The strategy does especially well when merger activity increases, Ms. Subramanian says. It beat the P/E-based strategy by 25% during the 1980s, and by 18% during the previous decade's private-equity boom. With bidding wars breaking out over companies in recent weeks, the strategy could get another boost.

But broader economic factors are increasingly driving the stock market these days. Just look at the events of this week. On Aug. 30, the Dow Jones Industrial Average fell 1.4% after personal-income data came in weaker than expected. But on Sept. 1, it rose 2.5%, as the Institute for Supply Management's factory index rose to a three-month high.

The upshot: Individual company valuations "are virtually irrelevant in today's economic climate," says Jeffrey C. Sica, president of Sica Wealth Management in Morristown, N.J., which manages about $1 billion.

To get a handle on changing economic sentiment, Westpac Banking Corp. looks at the percentage of newly released economic data that beat estimates over a rolling eight-week period. Westpac says when the index is near 60% or greater, it could signal the start of a disappointing economic trend; when it is near or below 40%, it could augur the start of a positive trend.

The "surprise index" hit 62% in January and traded near 60% again in March. In both cases, the S&P 500 dropped soon after. Now it reads about 41%, at the bottom of the normal range. "The bad news may be as bad as it can get," says Richard Franulovich, a Westpac strategist in New York. "If it drops to 30%, I will be swinging for the fences."

Another method, says Jim Stack, president of InvesTech Research in Whitefish, Mont.: watching the stocks on the New York Stock Exchange that are hitting new 52-week lows. If that number stays above 100 for five consecutive days, a bear market may be on its way. Likewise, when the number remains low for an extended period, it can signal that a bounce is imminent.

The metric remained above 100 for three consecutive weeks starting on July 20, 2007. Less than three months later, the S&P 500 peaked at 1,564.7 before dropping 57% during the following 17 months. Conversely, new 52-week lows fell to 14 four days after the market bottomed on March 9, 2009, and remained below 20 for much of 2009, as stocks rallied.

The tally for new 52-week lows hasn't stayed elevated in 2010. Despite large market drops, the figure topped 100 for only three days when the market hit lows at the end of June. It quickly reversed—by July 13, only six stocks hit new 52-week lows—and the market rallied 10%. It topped 100 again on Aug. 24 and 25, the recent bottom, before falling back to 38 on Aug. 26. The market rallied 3.3% during the ensuing six days.

Says Mr. Stack: "We haven't seen the downside leadership that usually accompanies a bear market."

 
 

Questions:

  1. What are the different valuation ratios considered in the article?
  2. What is the problem with the P/E ratio?
  3. The "net revisions" number is computed as Net Revisions = (#upward revisions - #downward revisions)/Total revisions. According to the article, this measure can be used to tell whether investors are becoming more or less negative. Why?
  4. Why is enterprise value/free cash flow more reliable to measure a firm's value?
  5. "Savita Subramanian, head of quantitative strategy at Bank of America Merill Lynch in New York, says a strategy of buying the 50 cheapest S&P 500 stocks based on the enterprise-value-to-free-cash-flow ratio has outperformed a similar strategy using forward P/Es by at least 2% since 1986, with less volatility." What do you think of this strategy?