Why Are P/E Ratios So High?

Over the years the average P/E ratio for stocks in the S&P 500 has been between 13 and 15. When earnings go up the P/E ratio goes down. Investors buy and the P/E ratio comes back up. But, why are P/E ratios so high today? Tesla has a P/E ratio of more than 1,000. Amazon has a P/E ratio of 120. Netflix has a P/E ratio of 83. Apple has a P/E ratio of 17. Why are P/E ratios so high for Netflix and Tesla? The reason is that enough investors believe that Tesla will become the dominant company in the electric car industry and that Netflix will dominate the streaming content niche. In addition, with interest rates at historic lows, even over-priced stocks can look attractive.

Disadvantages of Using P/E for Valuation

During a bear market the P/E ratio of a stock may be misleading. When we consider the intrinsic value of a stock, we look to the future and not the immediate present when the business cycle has slowed down. And, a steadily growing stock that is coming to dominate its market niche will typically have a high P/E ratio as investors want to get in before the price goes even higher. But, if a company is really failing and its stock price is falling, the P/E ratio may mislead investors into thinking that the stock is stable.

P/E and PEG Ratio

When you are factoring growth into the equation for a stock, the PEG ratio can offer more insight than the P/E ratio. The PEG ratio is the price and earnings to growth ratio,

PEG = (P/E ratio/Annual Growth Rate)

In the best of all possible worlds, the PEG of a fairly priced stock should be one. Market Watch writes about the “three stock markets” and warns that FAANG stocks with high P/E ratios are overpriced, stocks traded by the Robinhood investors are crazy, and the rest of the market has value if you can find it. Their observation is that the P/E ratio makes sense in the broader market while the FAANGs are priced too high and the choices of most Robinhood investors make little or no sense.

If you are interested in a stock like Tesla, a better approach than the P/E ratio is to compare their progress to that of companies like General Motors, Ford, and Volkswagen. The winners in the race to dominate the electric car market will necessarily be the ones that are flashy today but the ones who are most efficient and profitable in the long run.

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Successful Investing by Seeing the Future

We commonly use intrinsic stock value as a guide to successful investing. This approach assumes that you can successfully predict the income stream that an investment will generate in the coming years. Then, you look at the current stock price as well as the financial condition of the company. Here is where the Generally Accepted Accounting Practice that is used to do the books may not serve a modern investor very well. There are factors that may overstate the value of a so-called “value stock” and understate the value of a so-called “growth stock”. The Wall Street Journal looks at the traditional way of measuring value stocks and offers some advice to investors.

Is “value” dead? Or have we just been measuring it in the wrong way?

It’s an urgent question, because value stocks-when defined according to the traditional criterion, low price-to-book-value ratios-have lagged behind growth stocks for at least a decade now. And though value stocks in the past have come roaring back after going through similarly long periods of lagging, some researchers are questioning whether they will do so again.

The point that the WSJ makes hinges of how “intangible assets” are treated in the world of accounting.  What is important when predicting the future of a stock is being badly represented in financial statements.

That’s because a growing percentage of companies’ market value now comes from intangible assets-things like patents, trademarks and research-and-development expenditures-that are either ignored in the book-value calculation or reflected inconsistently. Therefore, the researchers say, the price-to-book ratio has lost its relevance.

If they are right, we can’t expect stocks with the lowest such ratios to reassert their historical dominance over stocks with the highest ratios.

Stocks that keep going up are those that keep increasing their earnings. The value of many of these companies lies in their names, trademarks, and patents. The money that they pour into R&D comes back as new products, more efficient ways to produce their products, dominance of their market niche, and creation of totally new market niches. The market keeps rewarding the companies that are following this path because their earnings are steadily increasing. Which growth stocks are really value investments? The first trillion dollar company, Apple, fits the mold of a company that is steadily growing based on continual product improvement, strong R&D, and lots of patents. Johnson & Johnson and Microsoft, the only two companies with AAA corporate bonds as mentioned in our article about how to invest without losing money, also fit the mold. Until they change the way that “intangibles” are reported by the accountants, earnings may be the best guide to picking “value stocks.”

Which Growth Stocks Are Really Value Investments? PPT

Should You Use Earnings or Growth as a Guide When Picking Investments: Overpriced growth stocks

The Toronto Globe and Mail has an interesting article about this subject. They point out a long term problem with growth stocks.

There is plenty and unequivocal evidence from academic research in Canada and around the world that, on average, value stocks (defined as stocks with low price-to-earnings or price-to-book ratios) beat growth stocks (those with a high P/E or P/B). For example, in recent research I carried out using U.S. data, I found that, on average, value stocks beat growth stocks by about 6 per cent over the 1982-2013 period.

The problem with popular growth stocks is that they become too popular and their prices get bid up beyond what fundamentals would support. We repeatedly suggest the use of intrinsic stock value as a guide to investing. In our article we pointed out that understanding how a company earns money and will continue to do so is basic to using intrinsic value as a guide to investing.

The ability to see into the future to see how well a company will manage its assets, products, costs, R&D, and marketing is of utmost importance in calculating intrinsic stock value as a means of deciding whether or not to purchase a stock.

The often repeated quote from Warren Buffett is useful in this case. He has tended to avoid tech stocks and focus on consumer stocks with strong brand names. This is because he does not know what a given tech stock will be worth or if it will even have a market in five years. But he has a pretty good idea that a product like Coca Cola or Snickers will be selling for five and ten years hence.

Should You Use Earnings or Growth as a Guide When Picking Investments: Underpriced value stocks

When investors look at the market they see certain stocks going up in price and other stocks languishing on the sidelines. There is a natural tendency to buy the stocks that are going up in price and ignore those that are on a flat price line. The fact of the matter is that when lots of investors pick growth over value they distort the market. Smart long term investors use this fact to pick up bargains for the long term.

Should You Use Earnings or Growth as a Guide When Picking Investments: Short Term Investing

The place for the majority of growth stocks is with short term investment. Good examples would be Microsoft from its IPO until just before the dot com bubble burst or at the depths of the Great Recession until now.

Should You Use Earnings or Growth as a Guide When Picking Investments? PPT

Emerging-market stocks rose toward the highest level since China’s currency devaluation last year, while volatility fell to an 11-year low, on optimism earnings are improving and central banks remain supportive of growth.

More than half of developing-nation companies that have reported financial results for the last quarter have beaten estimates, following similar positive momentum in the U.S. and Europe.

The MSCI Emerging Markets Index climbed 0.5 percent to 874.98 at 9:22 a.m. in New York, heading for the highest since Aug. 11 and tracking gains in Europe after the U.K. reported second-quarter growth that was quicker than estimated. Eight of the 10 industry subgroups on the developing-nation gauge rose, led by technology companies.

The old wisdom is that the best time to buy stocks is when things are at their worst. The problem is knowing just when that is and not investing your money at the beginning of a prolonged period of stagnation. Thus many investors look for the first sign of an uptick in order to buy and ride a bull market to profits. If this a good time to purchase, why buy emerging market stocks?

Strong Dollar, Offshore Bargains and ADRs

The US dollar is strong and will likely get stronger as interest rates go up in the USA. The current best guess is that rates will go up in December and not before. Nevertheless, a strong dollar makes stocks in foreign countries cheaper, even if you purchase them via American Depositary Receipts (ADRs). You hope, of course, is that when the dollar weakens and the foreign currency gets stronger that your investment in that country will profit both from the business and from the exchange rate. The web site Top Foreign Stocks offers lists of foreign ADRs available from Austria through Zambia. Here is Zambia.

• Copperbelt Energy Corp: Electricity
• Zambeef Profits: Food Producers
• Zambia National Commerce Bank: Banks
• ZCI Limited: Industrial, Metals, Mining

We are not suggesting that you buy any of these specific stocks but rather suggest that you look at companies that make money within the country instead of exporters. This is because virtually all commodities are denominated in US dollars so the exchange rate changes make little difference to the value of the stock. But in a growing economy the service sector can prosper and your profits will be denominated in an eventually stronger currency.

ADRs and Analysis of Intrinsic Value

Successful long term investing requires that you look at the intrinsic value of the stocks that you buy, hold or sell. The value of ADRs is that first of all you do not need to speak a foreign language or buy stocks in a foreign market. And secondly top level ADRs provide the same sort of financial info that US stocks do which allows you to make an accurate assessment. To the extent that you spend the time researching emerging market stocks and make reasonable picks you will have a stock portfolio that is nicely diversified across currency exchange rates and various world economies.

Why Buy Emerging Market Stocks? PPT

Stock splits might be one of the last corners of the market where emotion seems to trump logic. There’s absolutely no quantitative difference between owning 100 shares of a $20-a-share stock and 200 shares of a $10-a-share one following a 2-for-1 split.

Yet, there have been 41 stock splits by companies in the Standard & Poor’s 500 over the past three years. These stocks are up an average of 33% from the time they split to Wednesday’s close – topping the Standard & Poor’s 500’s average gain of 23.6% during the same time. That means holding all the companies’ shares that have split – on average – has been a winning strategy.

Why is this? Is it all perception? Here are two thoughts that come to mind.

Buying in Round Numbers

Certain types of investors like certain stocks and they like them at a certain price. If you have $5,000 to invest every quarter and you would like to buy 100 shares you might decide to stock with your regular $50 a share stock. If the stock climbs to $85 a share and then splits you can get your 100 shares for $4,250 and will be happy. There may well be people for whom this approach works.

Evidence of Success

Growth stocks run the risk of being overpriced. If Microsoft had never split it would be trading for tens of thousands of dollars a share today. Splitting the stock keeps the price where an investor can pick of a few shares within his price range. And, if a company splits their shares every few years it is because they are growing. Stock splits over time are evidence of success. NASDAQ talks about how to identify growth stocks.

Many investors attempt to find growth stocks, but how does an individual investor seek out and identify the best and brightest growth stocks for their portfolio?  A savoy investor looks for specific fundamental characteristics to unearth these companies.

First, growth traders look for companies that are expected to grow at an above average rate, corresponding to the market as a whole.  Further, analysts look for better than average cash flows, earnings, and or revenue growth.

When you invest in stocks that split routinely you are investing in stocks with stable and steady growth.

Growth and Value

The Motley Fool asks if a growth stock can be a value stock.

Can a growth stock simultaneously be a value stock?

The answer to this question is yes – though, it’s an uncommon occurrence. Normally growth stocks trade at premium valuations indicative of their growth rate. However, once in a blue moon, a growth stock comes along that also has a relatively low P/E and PEG ratio (a measure of future revenue growth relative to P/E), qualifying it as a value stock as well.

They give three examples, Gilead Sciences, 3D Systems and Apple. Apple does not generally split its stock but it may eventually have to. The point is that when you invest in stocks that split you are investing in growth and value.

Invest in Stocks That Split PPT

From 1926 through 2013, dividends have represented nearly 43% of the returns generated by the stock market, as represented by the S&P 500 index.
Stocks of companies that grow and initiate new dividend payments, [such as those the Fund seeks to own] outpaced other alternatives.
What makes these results even more compelling is that stocks with growing dividends have not only outperformed, but have done so with less risk.

Why invest in dividend stocks? Companies that routinely pay dividends have good cash flow. They make money because they have a successful business plan. Companies that pay dividends are often easy to understand. They sell products that people want, will buy and will continue to buy into the future. And strong, stable dividend stocks typically are not bargain stocks. So, how do you find a good deal when looking for dividend stocks?

Bargain Hunting Dividend Stocks

The Street comes to the rescue! The publication lists their ten most undervalued dividend stocks.

Dividend stocks often fall off the radars of investors looking for total returns but dividend paying stocks greatly outperformed non-dividend paying stocks from the period from 1972 through 2013. The compound annual growth rate of dividend paying stocks and non-dividend stocks from 1972 through 2013:

Dividend Paying Stocks: 9.3% per year
Non-Dividend Stocks: 2.3% per year

Dividend paying stocks have been a better investment than non-dividend paying stocks over the past 40 years. Investing in dividend stocks is not the only strategy that has a long history of outperformance. Value investing has also significantly outperformed the market over long periods. Stocks with the lowest 10% of price-to-book ratios have outperformed stocks with the highest 10% of price-to-book ratios substantially from 1926 through 2013 (an 87-year study). The compound annual growth rate results:

Lowest 10% price-to-book ratio stocks: 12.6% per year
•Highest 10% price-to-book ratio stocks: 8.6% per year

The first suggested stock in the article is Tupperware. There is nothing glitzy about this company. It has a 14.8 P/E ratio and pays a 4.3% dividend. Read the article for more info. Those looking for solid returns over the decades look for value in well run companies that generate steady and reliable cash flow. That is why invest in dividend stocks.

Picking Dividend Stocks

Let us say that you are not bargain hunting but simply want the best dividend stocks for your portfolio. CNN Money has an opinion about how to pick the best dividend stocks.

Disney (DIS), Starbucks (SBUX), and TJX (TJX) (parent company of T.J. Maxx) show that investing in businesses with increasing dividends and healthy fundamentals can be the key to outperforming the markets in the long term.

The importance of dividend growth: According data from Goldman Sachs, dividend stocks tend to outperform their nondividend-paying counterparts by a considerable margin over time. A $10,000 investment in nondividend stocks in 1972 would have turned into $26,417 by 2013, while investing the same amount in dividend-paying stocks would have resulted in $413,073.

The point is to look for dividend growth. Companies that are solid very commonly reward their investors as sales and profits rise. Companies do not like to reduce their dividends so they only raise them when they expect continued strong cash flow. That is why invest in dividend stocks, specifically where dividends continue to go up.

Why Invest in Dividend Stocks? DOC

Why Invest in Dividend Stocks? PDF

Why Invest in Dividend Stocks? PPT

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Low Risk, Low Returns

Dividend stocks are still a good idea when you are retired. They send you a check every quarter, may appreciate in value and may increase dividends over the years. In looking at stock picks for 2014 we looked at a collection of utility stocks. We noted that if you wait until interest rates go up you can buy these stocks for less than they sell for now. This is because these companies to do not grow fast and their stocks are an alternative to bonds. Thus their dividends remain stable over the years and the value of the stock moves opposite to interest rates. When rates go up as the Fed cuts its stimulus program the rate of return on these stocks will go up as they will become bargains. Thus, a good way to make money in retirement is to buy utility and other dividend stocks when interest rates are high. You can hold these stocks forever or you can sell for a tidy profit when rates go down.

Speculative, Cheap and Potentially Lucrative

They say that a good way to avoid or slow the arrival of Alzheimer’s disease is to learn something new in your old age. If what you learn is all about high tech and bio tech growth stocks you can also make money in retirement. The money to be made in biotech is typically when a new company succeeds in getting FDA approval for a new drug. The hurdles put in place by the FDA are meant to make sure that a drug works as promised and that it does not have bad side effects. At first drugs are tested on animals and then they are tested in three phases on humans. At each step the price of the stock of the bio tech company may sky rocket if the drug passes. An investor does not need to invest a lot of money to make a lot with these stocks. It is largely a matter of timing. Buy a few shares well in advance of the announcement of results of phase one, two or three testing. Then sell when the stock bumps up in anticipation of good results. This type of investing takes time and patience that you have as a retired person. And you get to learn new things along the way. And, as always do your own fundamental analysis of investments and be wary of tips.

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Learn to Read the Fundamentals

Fundamental analysis is the basis of a no-nonsense approach to stock investing. Sound investing is based on your own analysis and not on stock tips. If you subscribe to a stock alert service, that can be valuable. But you need to be adept at finding the margin of safety of a stock in which you are interested. Another question for no-nonsense stock investing is what is intrinsic value for the stocks that you evaluate? A stock with a low price to earnings ratio is often a good investment because the market is undervaluing it. This often happens when sales and profits go up and the market does not catch on. Buy this stock before the market realizes what a good deal it is and you will have a good long term investment to add to your stock portfolio.

Search for Value

A search for undervalued stocks does not end with a look at the price to earnings ratio. The intrinsic value of a stock is tied directly to anticipated long term earnings. Stocks in growth areas such as biotechnology can be great investments as a new anti-cancer drug or a cure for Alzheimer’s disease will be a cash cow far into the distant future. A no-nonsense approach to stock investing in this area requires that you do a bit of homework. Be especially careful of tips and do your own fundamental analysis. Stocks in biotech can rise and fall in price repeatedly as new products go through the FDA approval process. Although many traders seek to profit from the ups and downs of a stock in this sector, the goal of long term no-nonsense stock investing is to find a promising stock, get in early, and hold on until profits roll in. Because of the risk of holding a single one-product biotech stock many investors seek to hold several in order to balance out the risk of losing with an occasional big winner.

Stock Appreciation and Cash Flow

A good no-nonsense approach to stock investing for those nearing retirement is to invest in strong dividend stocks. In a person’s high earning years it makes more sense to invest in stocks with the potential to appreciate in value. As retirement nears a no-nonsense approach to stock investing suggests that you be in stocks that send a dividend check every quarter.

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Columbus and Stocks?

Some economies and some companies will emerge from the current financial mess stronger. Some will fade away. For the long term investor prediction and an appreciation of the very long term for growth stocks will be key. What will be the growth stocks for the really long term? The money behind the infrastructure that preceded the voyage of Columbus is a distant but useful example of disaster followed by technology transfer and world changing success.

A hundred years before Columbus sailed Christian Constantinople fell to the Muslim Turks and became Istanbul. Venice and other Italian city states lost their trade routes out of the Orient but still had large navies and merchant fleets that policed and traded across the Mediterranean. So what did they do? They sent sons and nephews, expertise, and money to the far end of the Mediterranean and established trade routes along the African coast culminating in the voyage of Vasgo de Gama around Africa to India from 1497 to 1499 and the voyages of Columbus and the conquering of the “New World” from 1492 on.

Take Home Points

Those who do not accept defeat often win in the end. A secure investment may well fade away and the correct “growth stock” may be the best bet ever.

In times like these, watch where those who have money are putting it and watch where they are putting their “growth stock expertise.” As US Homeland Security has effectively closed US borders to a lot of foreign born scientific talent that talent and money will go elsewhere. Already we are seeing many foreign companies with more US patents per year than any US company except IBM. The secure investment in “safe frontiers” may well deny the US the ability to develop the best growth stocks for the long term.

The investments you make in the goals you can imagine often result in unforeseen riches. Engineering and production cycles for new products have become shorter and shorter but when a new concept shows up it changes the world. Think of personal computers and genetic engineering. The point here is not to try to outguess the scientists but to watch who has the talent and where the money is going. Although Europe continued to fight the Turkish advance for a couple of hundred years as its secure investment it invested in the growth stock of American exploration and conquest which changed the world.

Thoughts about Today and Secure Investment versus Long Term Growth Stocks

We have made the argument on these pages that buying US treasuries, especially short term ones, is a secure investment for the coming months. We are seeing advice in the press that the best long term secure investment is to sit on your money. I read that as Venice letting its fleets rot and sending its sailors home to farm.

Where is the money going for R&D? Where are the best and brightest scientists going? Where is the culture conducive to independent thinking and the discovery of world changing ideas? I read this as Venice sending its expertise and money to the other end of the Mediterranean and jump starting the exploration that gave the Americas to the European culture. I read this as Korea, Taiwan, Japan, Great Britain, most of Western Europe as well as India, China, and the rest keeping their scientists at home and developing the ideas for growth stocks for the future.

The promised investment in US infrastructure is a good sign for growth stocks at home.