As Of: April 14, 2001

Why P/E Ratios Are Shrinking

An Explanation For A Falling Stock Market

      Recently, I came across the saying: "Never underestimate stupid people" and I began to wonder if that held the key to why I thought the market should have corrected years ago, and why some people were still surprised when it finally did start going down. I am sure a lot of very intelligent people invested in stocks, so the word "stupid" does not seem appropriate. I would perhaps replace it with the phrase "intelligent but ignorant". I suspect that a lot of otherwise intelligent people were not paying attention to fundamentals when they purchased stocks with price-earnings ratios in the hundreds (and in many cases purchased stocks with no earnings at all).

      Earnings used to be important because they were the resource from which companies could pay dividends to shareholders. However, over the last twenty-five years, dividends have become increasingly less important to investors. Stocks used to be perceived as more risky than bonds, and dividend yields often exceeded U.S. Treasury rates. By 1984, the dividend yield on the Standard & Poor's 500 Composite Index had dropped to 4.50%. The payout dropped steadily every year thereafter to 1.14% in 1999. There are many reasons why dividend payout has dropped (including unfavorable tax treatment), but the result has been to shift the reason for stock ownership away from income toward an emphasis on growth in share price. Growth in share price is primarily dependent on growth in company earnings. Thus we have the price-earnings ratio (share price divided by annual earnings), a measure of what a stock should be priced at in relationship to its earnings.

      Just as the dividend yield has experienced a multi-decade drop, the price-earnings ratio has experienced a multi-decade increase. During the late 1940's and during the 1974-1981 period, the P/E ratio was as low as 7. It was never higher than the low 20's. In 1984 the P/E ratio of the S&P 500 was 10.05. It increased steadily to the mid 20's by the early 1990's and to over 30 by the end of the 1990's. As we all know, the stock market soared during the last decade. What most people are perhaps not aware of is that the increase in stock prices was due more to an expansion in P/E ratios than to an increase in corporate earnings. At a P/E ratio of 10, the S&P 500 should have hit a high of 537.30 in 2000. At a P/E ratio of 15, the index should have been at 805.95. The index actually reached 1527.46 giving it a P/E ratio of 28.42 (down from a year-end high of 32.57 in 1998).

      What is wrong with a high P/E ratio? Many analysts felt that a higher P/E ratio was justified because interest rates were declining during the 1980's and 1990's. There are many arguments to support higher stock prices when interest rates go down, but I suspect that the P/E expansion was heavily driven by hugely inflated earnings expectations (particularly in the technology sector). Earnings in the S&P 500 doubled during the seven to eight year period from 1986 to 1994, and they were on track to double again by 2002. This works out to a 9% to 11% year-over-year growth rate in earnings; but with its optimistic exuberance, the stock market pushed prices up by 20% to 30% per year. The difference between inflated expectations, as reflected in share price, versus actual earnings growth can be seen in the following chart.

      If the P/E ratio had held steady at any level, the market would have experienced excellent growth. But the added expansion of P/E ratios created stupendous growth. And then along came earnings disappointments.

      In a period when earnings drop, a high P/E ratio is especially harmful. A simple way to look at a P/E ratio is to understand that a P/E of 10 means it will take ten years of a company's earnings to equal the price that is being paid for the company's stock. When Coca Cola had a P/E of 50, it meant that investors would have to wait 50 years for the company to earn back the value that investors were paying for its stock. Obviously investors don't want to wait 50 years or 30 years just to get their money back. The reason that an investor might be willing to pay for a stock with a high P/E ratio is because of an expectation that earnings will dramatically increase and the P/E ratio will therefore decrease. If an investor buys at a 30 P/E ratio and the stock actually grows earnings at 20% per year, the investor will earn back his investment in ten to eleven years instead of thirty years. A big problem develops when expectations are not met.

      An investor who buys a stock with a P/E ratio of 10 and experiences a disappointing 5% growth in earnings instead of an expected 20% growth in earnings, will have his payback period stretched out from 6 years to a little over 9 years. Perhaps not a happy situation, but not a disaster. As you can see from the chart below, the investor who buys a stock with a 30 P/E ratio and experiences exactly the same disappointing lower growth in earnings will find that his payback period is stretched from more than 10 years to more than 18 years. This 80% increase in the payback period is unacceptable and the P/E ratio needs to drop substantially.

A low P/E = lower risk if earnings do not grow as expected.

      Of course, initially, investors want to believe that the slowdown in earnings is just a temporary hiccup, and dramatic earnings growth will continue. Once it is perceived that a high P/E is pricing in perfection compounded, then the cost of dropping back to reality, plus adding a risk premium for uncertainty, necessitates a devastating contraction in P/E ratios. Any way that you crunch the numbers (unless you are still clinging to the hope that this is not a recession - just a temporary hesitation), you will come to the conclusion that P/E ratios are likely to drop further and the Standard & Poor's 500 needs to go down further. There is of course the possibility that the market just flatlines until earnings can catch up. Whether it is a further drop or a sideways correction from here, there is no reason to get too bullish any time soon.