Research & Advice

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Valuations

March 6, 2009

  • Price-to-Earnings (P/E) ratios are extremely useful because they allow investors to better assess the probability of the stock market rising or falling in the long-term.
  • P/E ratios are not helpful as timing tools.
  • Calculating P/E ratios is not an exact science because 1) forward-looking P/Es must forecast (guess) the “E” and 2) there is debate as to what types of earnings should be considered.
  • The average P/E trough during past recessions is just 11 times expected earnings.  Adjusting for inexactness of the P/E science, the S&P 500 stock index is priced somewhere between the most bearish and the most bullish cases (where the index should be valued somewhere between 500 and 1,000 points).  The resultant calculations guide us in determining the re-investment process for all of the cash held by Berkshire Money Management clients.

The standard metric for valuing the stock market is to compare the price of stocks against the earnings of the companies they represent.  That metric is called the price-to-earnings ratio (or P/E ratio). 

P/E ratios (or any type of valuation metric, really) are extremely useful because they allow investors to better assess the probability of the stock market rising or falling in the intermediate-to-longer term (think more than a year). 

P/E ratios, however, (again, or any type of valuation metric) are not as helpful as a timing tool.  For example, just because stock prices have fallen to a level where the stock market is cheap enough where it makes sense to buy-and-hold stocks for the long-term, it doesn’t mean that they can’t get cheaper in the short-term as prices continue to fall. 

In reality, of course, there are no tools (or even combination of tools) that can be used to consistently and accurately call (or even come close to calling) the top or the bottom of stock market cycles.  To lend credibility to that claim, consider a passage from Warren Buffet’s October 17, 2008 NY Times editorial “Buy American.  I am.”

Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.”

Ergo, the use of P/E ratios is not to time the market in the short-term, but to assess the probability of success in the long-term.  And that is a good thing.

The bad thing is, however, that – believe it or not – earnings are confusing.  They are confusing because it is important what companies will earn, not what they did earn.  So there is an attempt at forecasting which, by its very definition, implies the possibility of human error.  But that’s obvious.

The not-so-obvious component of what makes earnings confusing is that you have to decide what type of earnings to use.  Stocks can be called either fairly cheap or rather expensive, depending on which set of corporate profits you use in your calculation.

Public companies report at least two kinds of earnings.  There are “as reported” earnings, which are what we would call “actual” earnings and are pretty close to GAAP (generally accepted accounting principles) earnings.  And then there are “operating earnings” (often called “earnings before bad stuff”).

When a company takes a write-off they nearly always claim the loss is “non-recurring.”  Therefore, to look at ongoing operations, the write-offs are put back into operating earnings as if they did not happen.  Theoretically, that works. The problem is that these so-called non-recurring expenses often recur (even if not the exact same ones, something seems to always come up). 

Operating earnings are part of the era of financial engineering that started in the 1980s, so operating earnings were only calculated back to 1984.  Since 1984 operating earnings have averaged about 12.7% more than as reported earnings.  That’s not an enormous gap and is close enough to use in an inexact science such as valuing stocks.  However, 2008 numbers showed a much wider gap – 2008 operating earnings ($54.60 for S&P 500 companies) were about twice 2008 as reported earnings ($26.10 for S&P 500 companies).

So how do we reconcile the two types of earnings?  Theoretically (and what was true during the 1991 and 2001 recession), operating earnings have validity deep into recessions (like now) when as reported and GAAP earnings are unduly depressed. 

When you look at past recessions, the average P/E trough during a recession is just 11 times forward earnings.  Of course, that is a much easier calculation in retrospect because history allows you to compare actual versus expected earnings.  But for simplicity sake, if we expect 2009 earnings to equal 2008 earnings (i.e. no year-over-year growth), then you can expect a bottom for the S&P 500 (using operating earnings) at 600 points ($54.60 x 11).  If you ascribe a ten-percent gain in earnings from already depressed levels, then you can expect a bottom for the S&P 500 at 660 points. 

Again, this is using an average – in this cycle the monetary base is huge, interest rates and inflation argue for higher valuations, and a nearly $800 billion stimulus package was just signed into law.  So it wouldn’t be flawed to expect a P/E trough of, say, 13 instead of 11 (adding more confusion to the process).  That would bump those two aforementioned S&P 500 bottom numbers to 710 points ($54.60 x 13) and 781 points, respectively.

Looked at another way, the stock market has historically bottomed when the trailing P/E ratio (using the 12-months of past earnings as opposed to guessing what is going to happen) has been 18.76.  So if you look at trailing earnings for S&P 500 companies using as reported numbers, you could expect the bottom of the S&P 500 to be about 489 points (18.76 P/E x $26.10) or 1,024 points (18.76 x $54.60). 

See what we mean about confusing? 

Bottom Line:  Using the standard and time-tested P/E metric we just came up with a range on the S&P 500 from 500 points to over 1,000 points!

With the S&P 500 trading at about 725 points, at least we are in the bottom half of that range. Acknowledging that we do not know where the market will go in the short-term; does an investor buy now, before the stock market races back up to 1,000?  Or does an investor wait until the market drops another 15-20%?

The answer to that question is, of course, more customized to each client.  But to be very general, we are big buyers of equity if the S&P 500 drops to 600 points (that’s about equivalent to Dow 5,500).  But we aren’t too concerned if we continue holding all of our cash as the market moves back up to S&P 1,000 without us.  Our emphasis right now is on risk management, not investment management.

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