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Posted by Elizabeth Richardson on December 31, 2008, 3:33 pm
The advice thread has gotten long and tedious. I think there are some who
might be confused as to how a P/E is determined. Being no expert, rather a
long-time observer, I'm sure there are others who can explain it better than
I. (But that won't deter me from trying.)
My understanding is that the price of a company's share of stock is that
which a buyer is willing to pay for $1 worth of dividends in the future;
thus, price/earnings. It is that willingness to pay which is crucial to
acknowledge, willingness often not based on facts. It is not the company who
determines the price of the share of stock as most shares are sold by others
owning the shares rather than company owned shares. Thus, movement up or
down in the stock market is based largely on people's perceptions of a
future event, an event which cannot be forecast to 100% accuracy.
The discussion has been not on the P/E of a particular company, but on the
P/E of an index. Discussing whether the P/E of General Motors will go up or
down is not what is being discussed in the other thread, but that of a
basket of 500 stocks. Evidence is more likely to exist for the movement of a
particular stock, but the movement of a basket of stocks is more likely to
be influenced by human behavior, and human behavior has evidence in a
historical perspective rather than current events.
That historical perspective tells me that people will be looking to make
money buying stocks that they perceive as being cheap and it appears there
are many who believe stocks are cheap now. Therefore, based on the law of
supply and demand, stocks are poised to increase in price.
Elizabeth Richardson
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Posted by on December 31, 2008, 4:32 pm
This logic is pretty darn persuasive, assuming I am parsing the
sentences in the first post here correctly. I think maybe I would not
use the word "poised," because of the example of the 1970s, for one,
when stocks and P/Es alike stayed rather flat. OTOH, I can buy the
notion of stocks being poised for a decade or so.
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Posted by dapperdobbs on December 31, 2008, 5:38 pm
wrote:
>
> It is that willingness to pay which is crucial to
> acknowledge, willingness often not based on facts.
Elizabeth -
Very nice description of Mr. Market :-) You hit on the critical points
of pricing. I'd just note that the PE is the price divided by the
earnings per share. Usually, yield is given as a percent of price, but
the 'price to dividends per share' is useful as a comparison to 'bond
price per annual payment'. At Wednesday's close, for example, the
Price to Annual Yield on the ten year Treasury works out to 44.56. The
reason for that high ratio is the presumed assurance of the interest
payout, and the assurance that all of one's capital will be returned
on schedule. AT&T's px to div ratio is 17.39, for comparison.
The earnings are critical for an evaluation of the company's
operations. Some are more predictable than others. As earnings
increase (if they do), more dollars become available for dividend
increases, and as long as the future of the company looks good, the
price of the stock will tend to rise. Since stock dividends are paid
from earnings (with few exceptions), the proportion paid out is called
the payout ratio. A lower payout ratio lends more confidence that the
dividend will be sustained during a temporary decline in earnings.
With bonds, neither the interest payout nor the redemption price vary.
Under most market conditions, historically, bond yields have exceeded
dividend yields. With an emphasis on capital appreciation (or
depreciation) in stocks, many people focus on the price of the stock,
but that's really the tail wagging. The earnings are the thing to
watch.
You're absolutely right "that people will be looking to make money
buying stocks that they perceive as being cheap" - those people are
usually known as the "smart money" :-) those who have done their
homework in estimating the future earnings stream, and thus have some
sound basis for their confidence.
- George.
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Posted by on January 1, 2009, 7:29 am
> wrote:
Since stock dividends are paid
> from earnings (with few exceptions), the proportion paid out is called
> the payout ratio.
It seems to me that this provides a simple test of whether or not
retained earnings are increasing share value by a corresponding
amount. The stock price should increase at a rate of (1-PayoutRatio)/
(P/E). You could think of 1-PayoutRatio as the RetainedRatio. So if
a stock has a PayoutRatio of 25% and a RetainedRatio of 75% and a P/E
of 10, the stock should increase in value annually by 7.5% simply due
to retained earnings. Change the P/E to 20 and the increase in value
should be 3.75%. If this stock doesn’t increase in annual value at
this rate then retained earnings are being burnt up in friction.
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Posted by Ron Peterson on January 1, 2009, 10:47 am
On Jan 1, 6:29 am, camg...@att.net wrote:
> It seems to me that this provides a simple test of whether or not
> retained earnings are increasing share value by a corresponding
> amount. The stock price should increase at a rate of (1-PayoutRatio)/
> (P/E). You could think of 1-PayoutRatio as the RetainedRatio. So if
> a stock has a PayoutRatio of 25% and a RetainedRatio of 75% and a P/E
> of 10, the stock should increase in value annually by 7.5% simply due
> to retained earnings. Change the P/E to 20 and the increase in value
> should be 3.75%. If this stock doesn’t increase in annual value at
> this rate then retained earnings are being burnt up in friction.
You're assuming that the P/B ratio is 1. If the P/B ratio is 2, than
the stock will increase 15% in value annually and if the stock didn't
pay dividends, the stock would increase 20% annually.
Investors should be warned that book value may contain accounting
entries such as goodwill and intangible assets which may not
contribute to the the financial health of the company. A more
conservative investor will look at tangible book value instead.
Companies may try to buy back their stock, but if the stock price is
at a considerable premium to book value, book value will be diluted
just as options granted to employees may dilute the book value if
issued below book value.
--
Ron
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