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P/E Should Stand for Profit Expectations

© Kirk Lindstrom

Guest Article

By Rande Spiegelman of the "Ask Rande" discussion thread. This is the Q&A discussion thread where Rande Spiegelman shares his vast experience and knowledge with investors at all levels. Rande has the true gift of being able to address the novice investor questions as well as those from an experienced pro.

The following article first appeared here on March 18, 1999 and covered a topic that every investor needs to understand, even if they choose to ignore it when evaluating stocks.

Thanks Rande, for all your patience and time.

P/E should stand for Profit Expectations

What about the price-to-earnings ratio. Simply, the p/e is the price of a stock divided by its earnings (trailing or expected). A stock that trades for $20 with expected earnings of $1 per share has a forward-looking p/e of 20. With no growth, it would take 20 years for an investor to recoup the investment (which is why you hear that some stocks are discounted to the "hereafter"). Of course, growth expectations play into how much investors are willing to pay for the stock. The p/e is also heavily influenced by interest rates and inflation. Low inflationary expectations make the earnings more reliable and lower interest rates help in a couple of ways -- they enhance the profitability potential for companies and reduce the competitiveness of alternative fixed-income investments.

The p/e is only one of many factors in evaluating a stock. Many believe the concept of EVA (economic value added) is a much better indicator of a company's worth. Others focus more on free cash flow. I like the idea of cash flow as a barometer of value since this is what any reasonable person would look at when deciding on whether to buy a business or not. The question of whether the p/e is useless/outdated or the overriding factor to consider is somewhat specious. Of course the p/e is important, but it's not all-important. Any valid decision process should take into account a number of factors, not just focus on one.

I'm kind of a top-down, macro guy and tend to focus on the overall market in the context of the financial and economic situation. I have long used one of Greenspan's favorite formulas for figuring a "fair" p/e for the market, which relies on the 10-year Treasury rate. The 10-year's yield has had a good historical correlation to the market p/e. Simply divide 1 by the 10-year rate to arrive at a fair p/e and multiply by expected S and P earnings to come up with a "fair" market level (again, no one indicator is reliable -- just part of the puzzle). Here's an example:

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