figuring out price-earnings ratios (PEs)

One part of this is easy.

PE is industry jargon.  It’s a shorthand way of expressing the value of an individual stock, an industry group or a whole stock market, in terms of how many times one year’s earnings we’d be willing to pay to own whichever it is.

On the face of it, a low PE, say, 4x, would seem to be good; a high PE, say, 50x, bad.

But how do we know?  What factors enter into determining a PE?


A point that I’m maybe too fond of making is that, strictly speaking, there’s no demand for stocks.  There is demand for liquid investments, though (for most people in the US, it’s so they can save to send their children to college and to retire).  Bonds and cash are the other two big categories of liquid investments.  The apparent hair-splitting distinction is important, however, because each fixed income markets is much larger in size than stocks.  They’re also less risky.  The potential returns on these alternatives have a deep influence on what people are willing to pay for stocks.  In fact, academics turn the PE upside down (1/PE) to get what they call the earnings yield on stocks.  If you make the assumption that $1 in earnings in the hands of company management is more or less the equivalent as $1 in interest paid to you by the US Treasury, then the yield on Treasury bonds should (and virtually always does) have a powerful influence on what the earnings yield, and PE of stocks should be.  Why pay 20x for stocks if bonds are yielding 10%?

As I’m writing this, the 10-year Treasury bond is yielding 2.68%.  That’s the equivalent of a PE of 37.  This compares with a PE of 26 on the S&P 500, based on current earnings.   So either stocks are cheap or bonds are overpriced.

Today’s situation is very unusual, given that the financial meltdown in 2007-08 compelled the Federal Reserve to push interest rates down to intensive-care lows.  The consensus judgment of financial professionals, which I think is correct, is that bonds are unusually expensive today, not that stocks are dirt cheap.  If the 10-year is on the way to a 3.5% yield as the Fed returns rates to normal over the next year or two, then the equivalent PE on the S&P would be 28.5x.

That’s about where US stocks are now priced vs. bonds, which suggests that stocks are fully valued if we factor in the likely course of the Fed.  This suggests that only new positive information will move the overall market higher.

Now the going gets harder.

The second important point is the the stock market is a futures market.  That is, it is always pricing in tomorrow’s prospects as well as current earnings.  Willingness to pay for future earnings ebbs and flows with the business cycle, however.  During recessions, investors play their cards very close to the chest and look at most a few months into the future when pricing stocks.  In normal times, the market begins to price in the following year’s earnings in June or July.  In a very buoyant market, investors may pay for earnings two or three years into the future.


A third consideration, related to the second, and applying to individual stocks, is the rate of earnings growth.  The importance of this factor changes from time to time.  But a useful general rule is that the PE based on this year’s earnings can reach as high as the long-term growth rate of the company.  In other words, if earnings per share are growing at a 50% annual clip–and will likely continue to do so for the next several years (or at least there’s no easily visible bar to growth like this)–then the PE can be as high as 50x.


Generally speaking, the US economy can probably grow at about 4%-5% a year in nominal terms (meaning, including inflation).  If so, publicly traded companies, which are arguably the cream of the crop, will grow earnings per share by about 8% – 10% annually.  All other things being equal, this latter figure should be the trend growth for stocks in general.Put a different way, a company that can sustain growth of 50% a year in an economic environment like this must have something extra special going for it.

This rule of thumb doesn’t work for many “value” stocks, since no growth/earnings declines would imply a zero multiple–which in most (academics would say “all”) cases is clearly wrong (Academics say every stock retains at least a kind of option value).



business line analysis and sum-of-the-parts

This is mostly a reply to reader Alex’s comment on a post from early 2017 about Disney (DIS).

The most common, and in my opinion, most reliable method securities analysts use to project future earnings for multi-business companies is doing a separate analysis for each business line.  This effort is aided by an SEC requirement that such publicly traded companies disclose operating revenues and profits for each line of business it is in.

In the case of DIS, it’s involved in:  broadcast, including ESPN; movie production and distribution; theme parks and resorts; and sales of merchandise related to the other business lines.

There is plenty of comparative data–from trade associations, government bodies and the financials of publicly traded single-business firms–to help with the analysis.  And every company has, in theory at least, an investor relations department that answers questions put to it by investors. ( My experience since retiring as a money manager for institutional clients is that many backward-thinking well-established companies–DIS and Intel come to mind–can be distinctly unhelpful to their most important supporters, you and me.  (To be fair, I haven’t spoken with DIS’s IR people for several years, so they may be better now.))

Analysis consists in projecting revenues/ profits for each business line and using the results as the key to constructing a series of whole-company income statements–one each for this year, next year and the year after that.

The trickiest part is to decide how to value this earnings stream.  The ability to do this well either comes with experience or from having worked for a professional investor who’s willing to teach.


More tomorrow, or in a day or two if I don’t get my film editing homework done today.




~$70 a barrel crude (ii)

Two factors are moving the Energy sector higher.  The obvious one is the higher oil price during a normally seasonally weak time.  In addition, though, the market is actively looking for alternatives to IT.  It isn’t that the bright long-term future for this sector has dimmed.  It’s that near-term valuations for IT have risen to the point that Wall Street wants to see more concrete evidence of high growth–in the form of superior future earnings reports–before it’s willing to bid the stocks significantly higher.  With IT shunted to the sidelines for now, the market is not being a picky as it might be otherwise about alternatives such as Energy and Consumer discretionary.

The fancy term for what’s going on now is “counter-trend rally.”  It can go on for months.


As to the oils,

–a higher crude oil price is clearly a positive for the exploration and proudction companies that produce the stuff.  In particular, all but the least adept shale oil drillers must now be making money.  This is where investment activity will be centered, I think.


–refiners and marketers, who have benefitted from lower costs are now facing higher prices.  So they’re net losers.  Long/short investors will be reversing their positions to now be short refiners and long e&p.


–the biggest multinational integrateds are a puzzle.  On the one hand, they traditionally make most of their money from finding and producing crude.  On the other, they’ve spent very heavily over the past decade on mega-projects that depend for their viability on $100+ oil.  This has been a horrible mistake.  Shale oil output will likely keep crude well short of $100 for a very long time.

Yes, the big multinationals have all taken significant writeoffs on these ill-starred projects.  But, in theory at least, writeoffs aren’t supposed to create future profits.  They can only eliminate capital costs that there’s no chance of recovering.  As these projects come online, they’ll likely produce strong positive cash flow (recovery of upfront costs already on the balance sheet) but little profit.

The question in my mind is how the market will value this cash flow.  As I see it–value investors might argue otherwise–most stock market participants buy earnings, not cash generation.  Small companies in this situation would likely be acquired by larger rivals.  But the firms I’m talking about–ExxonMobil, Shell, BP…–are probably too big for that.  Will they turn themselves into quasi-bonds by paying out most of this cash in dividends?  I have no idea.

Two thoughts:

—–why fool around with the multinationals when the shale oil companies are clear winners?

—–as/when the integrateds start to show relative strength, we have to begin to consider that the party may be over.  So watch them.

~$70 a barrel crude oil

prices equity investors watch

Investors who are not oil specialists typically use (at most) two crude oil prices as benchmarks:

Brent, a light crude from under the North Sea.  Today it is selling at just about $70 a barrel.  “Light” means just what it says.  Brent is rich in smaller, less-heavy molecules that are easily turned into high-value products like gasoline, diesel or jet fuel.  It contains few large, denser molecules that require specialized refinery equipment to be turned into anything except low-value boiler fuel or asphalt.  Because it can be used in older refinery equipment that’s still hanging around in bunches in the EU, it typically trades at a premium

West Texas intermediate, which is somewhat heavier and produced, as the name suggests, onshore in the US.  It is going for just under $64 a barrel this morning.


What’s remarkable about this is that we’re currently nearing the yearly low point for crude oil demand.  The driving season–April through September–is long since over.  And for crude bought, say three weeks from now, it’s not clear it can be refined into heating oil and delivered to retail customers before the winter heating season is over.

Yet WTI is up from its 2017 low of $45 a barrel last July and from $57 a barrel in early December.  The corresponding figures for Brent are $45 and $65. (Note that there was no premium for Brent in July.  I really don’t know why–some combination of traders’ despair and weak end user demand in Europe.)


why the current price strength?

Several factors, most important first:

–OPEC oil producers continue to restrain output to create a floor under the price

–they’re being successful at their objective, as the gradual reduction of up-to-the-eyeballs world inventories–and the current price, of course–show

–the $US is weakening somewhat.



My Lighting class is calling, so I’ll finish this tomorrow.  The bottom line for me, though:  I think relative strength in oil exploration and production companies will continue.


EU insurance companies and coal–FAANGs the next step?

Yesterday’s Financial Times had a curious article, one with no immediate investment implications, but one that I thought was noteworthy anyway.  EU property/casualty insurance companies have decided they will no longer offer insurance coverage for new coal mining projects.  Their rationale is that ultimately they will be the ones paying out claims for damage that results from using this heavily polluting fuel.  So it makes no sense to make their situation worse by supporting the projects that lead to big loss payouts.


When I was looking for my first stock market job, I asked an interviewer why he had become a securities analyst and what was most satisfying for him in his work.  He replied that the best part of the job was in influencing investors through his reports to apply high price-earnings multiples to socially responsible companies (thereby making it easier for them to raise new investment capital), and low multiples to dishonest or socially irresponsible ones (making fund-raising harder).

Performing an important social service wasn’t what I’d expected to hear.  But over the years I’ve come to believe that, despite the cynical persona most professional investors adopt, very many–me included–think the way my old interviewer did.  This is one reason that tobacco companies, for example, are rarely market stars.

There may be enough problems with fossil fuels that low multiples are already permanently baked into the cake   …and that coal will continue to be a fertile ground for value investing.  I don’t think so, but who knows.

The more interesting question to me, though, is whether this thinking is being/will be applied to firms like Facebook, Google or Apple–serving as invisible anchors to the rise of their stocks.


IT: sector advances happen in waves

My first stock market industry coverage responsibility came in late 1978 at Value Line.  A more experienced colleague was poached by an institutional investor (nirvana for a VLer at that time).  Even though I had only a few months’ training, I became the firm’s oil analyst.

This was just as OPEC was repudiating Western colonial control of the world oil supply–the overthrow of the Shah of Iran in 1979 being a main catalyst.  Oil prices tripled.  Oil stocks shook off their typical bond-like torpor and began a raging two-year+ bull market.

The advance didn’t happen all at once, however:

–Small oil and gas exploration companies in the US, for whom rising prices had the most direct positive impact, rose first.

–Then came medium-sized, mostly domestic US-oriented, integrated firms (meaning they refined and marketed oil products in addition to exploring).  Most of these were subsequently acquired.

–Finally, the big Seven Sister-class international integrateds moved up, too.

This whole process, as I recall it, took most of a year.  The exact timing isn’t so important.  The pattern is, though, because it’s one that recurs.  In particular,  I think, it’s a useful tool to assess the massive tech rally we saw in 2017.

Wall Street then paused while it worked out whether there was more to go for.  It said there was.  And the whole three-tier process began again.

At the end of Round Two, the stocks were all fully valued by any conventional lights.  But international unrest continued   …and the three-tier process happened once more.  At that point the stocks were wildly overvalued.

Easy to say in hindsight, you may be thinking.  But there was a company back then called American Quasar that clearly signaled the excessive enthusiasm.  AQ was the exploration firm that discovered the Rocky Mountain Overthrust belt of trapped natural gas and ran tax shelters (always a danger sign) to finance their exploration.  In my view, Round One of the sector advance fully valued AQ’s reserves.  Round Two very fully valued its future exploration prospects, as well (this almost never happens).  Round Three placed a huge multiple on large prospective acreage it had just leased and had not yet drilled (which turned out to be the only parts of the Overthrust not to have any hydrocarbons).

In early 1981, the spot price of oil on commodity markets began to dip, initiating a three-year bear market in which many oil stocks lost 2/3 of their peak valuations.


The way I’m thinking about it, IT stocks finished Round One in late 2017.  To my mind, the sharp rise in Intel shares last September-November is like the big international integrateds finally participating back in 1979.  It signals that the valuation gap between firms exposed to the hot areas of IT and the large left-behinds had grown too wide.  Investors thought it made more sense to bet that INTC could lift its game than to buy more shares of an already high-flier.  It’s a red flag.

Now we’re in a wait-and-see period.  My guess is that there will ultimately be a Round Two.  But, as I’ve written elsewhere, IT is already about 25% of the total S&P 500 market cap.  That’s a daunting size.  My guess is that other sectors will have to rally in a way that reduces the IT weighting to, say, 20% before tech before more than the strongest tech names take off again.  But I think IT will ultimately rally.