Wednesday, April 8, 2009

P/E Valuations Skyrocket; Market Shrugs

Back in 2007 I wrote:

"So now with stocks priced at an entirely reasonable average P/E of 15.5 for the S&P, analysts scream BUY! But could they be forgetting the other half of the ratio? If earnings fall, can that bring the price down without affecting the ratio? Yes, of course."

One might be inclined to think that I was merely stating the obvious a full 18 months ago. Of course earnings could fall. Duh! But that wasn't the common perception at the time. In fact, it was quite a profound statement (to those that were listening). You would have been hard pressed to find more than a handful of Wall Street analysts who would have been willing to admit the possibility of earnings falling enough to have a significant impact on P/E valuations.

The rest is history, as they say. The same analysts had been, and still are, completely unwilling to acknowledge the reality of a contracting earnings environment. Quarter after quarter, the pollyannas making the earnings estimates forecasted massive increases in corporate profits, only to be greeted with massive losses once the reports came due. The worse the previous quarter's earnings, it seemed, the more optimistic they would become for the upcoming quarter. All along the way, a complicit media unquestioningly took these analysts word and proclaimed in unison, "STOCKS ARE CHEAP!"

How could this have happened, and why is it still happening? First, let us look at a few definitions. From Investopedia:

Forward Earnings: "A company's forecasted, or estimated, earnings made by analysts or by the company itself. Forward earnings differ from trailing earnings (which is the figure that is quoted more often) in that they are a projection and not a fact. There is are many methods used to calculate forward earnings and no single established way."

a) "Bottom Up" estimates are calculated by analyst's estimates of individual companies, added up and weighted to give an overall estimate of the entire index.

b) "Top Down" estimates are calculated using economic models of the overall economy.

Reported Earnings or Trailing Earnings: "The amount of profit that a company produces during a specific period, which is usually defined as a quarter (three calendar months) or a year. Earnings typically refer to after-tax net income.Ultimately, a business's earnings are the main determinant of its share price, because earnings and the circumstances relating to them can indicate whether the business will be profitable and successful in the long run."

Operating Earnings: There does not appear to be a consensus on what this means. Some define it as "earnings minus interest and taxes," while others define it as "earnings minus corporate expenses and unusual expenses." As far as I can tell, operating earnings are EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization.)

In order for one to have an understanding of what it means for a stock to be "cheap" or "expensive," one needs to define their terms. Just like if you were to accept a job in another country. You wouldn't have any idea whether the offered wages were good or not unless you had an idea of the cost of living in that country.

Sadly, a concept this basic is totally lost on our financial media. In interview after interview, analysts are given a floor to declare their opinions on this matter without first having to state their terms. Their declarations are then treated as gospel. No follow-up questions.

Indeed, there are many ways of valuing stocks. Some analysts recommend using P/E10. This is a 10 year average of reported earnings. The flaws in this should be quite apparent. Any major turn in corporate fortunes will leave one dwelling on the performance of nearly a decade ago. Additionally, if there is a long period of inflated earnings due to, lets say, an overabundance of credit, those earnings aren't necessarily indicative of a companies true earnings potential.

Other analysts will simply state something along the lines of, "based on historical averages, stocks appear fairly valued." But "historical" to these analysts may only be 5 or 10 years. Ask them to expand their perception of history to 60 years and the same statement becomes "based on historical averages, stocks appear overvalued by 80%" By simply changing one aspect of an input to the equation, the outcome can be completely opposite.

This is the same problem faced with climate models that suggest we will be 100m underwater by the year 2075. It is the same problem with economic models that suggest China will overtake the world by the year 2030. And it is the same problem with stock valuations. If you insert garbage into the computer model you are assured to get garbage on the other end. If you want a model to tell you something that you have already decided, you can simply tinker with the inputs and make the computer give you the answer you want.

This appears to be what is happening with stock valuations. We're being bamboozled. Yahoo Finance reports the P/E for the SPY (S&P ETF) as 8.83. I've repeatedly heard claims of a P/E ratio of 12 in the last few weeks. How are stocks really valued? The following is copied from S&P's website. They update this Excel sheet every two weeks or so.

The far right column is the trailing 1 year reported earnings. The column to the left of it is the trailing one year operating earnings. They are calculated by adding up the previous 4 quarters earnings and dividing by the current S&P 500 price. For example, the past four quarters reported earnings have been $15.54, $12.86, $9.73, -$23.16 = $14.97/903 = 60.37.

Because it is expected that the first and second quarters of '09 will be worse than those of '08, it is expected that the total 1 year trailing earnings will barely stay above water. Hence the skyrocketing P/E estimates north of 200.

Because of these astronomic valuations, analysts suggest that they are no longer of any use. So we are told to ignore the "one time charges" and instead focus on "core operating earnings."

The argument reminds me of that in favour of Diet Coke. Because your body doesn't recognize the sugars as food, rather a poison, it doesn't digest them and therefore produces no calories. Presto, Diet Coke is "healthy." Hardly.

Once again, it all comes back to asset deflation and the adverse effects it has on the balance sheets of these companies. For decades, companies had been writing up the values of their plant & property, goodwill assets, and their inventory. They used these write-ups to pad earnings quarter after quarter, year after year. Now, as the value of their office buildings and factories are declining, they have to write them back down. But to simply ignore the damage that declining asset values are having as "anomalous" is not only unprofessional but potentially fraudulent on behalf of the analysts and the firms that choose to do so.

To be fair, even a basket of stocks that has produced negative earnings for a year or even two does not necessarily have a value of zero. But the true value of a stock/business/rental property is it's ability to provide income to it's owner. Of course, eventually these write-downs will cease. But remember, many of these companies have just as much debt as they do equity. When the value of their assets is written down, their ability to sustain a certain debt load is reduced. They may not be able to refinance their debt and the creditors elect to liquidate the assets to recover as much capital as possible. In this case, the equity is indeed worthless. There is nothing different about this than with homeowners or commercial property owners. The tangible equity is wiped out and bondholders are left with the asset behind it.

The last time we were faced with a period of negative earnings was during the Great Depression. This was the reason for the Dow Jones losing 89% of it's value in 3 years. The sustainability of companies in the index came into question and therefore the equity became nearly worthless. This doesn't mean the whole company is worthless - such as is the case now with GM and Chrysler. Unfortunately, the debt/equity ratios are far higher now than they were back in the early 30's.

So how should we value the common equity for a group of 500 stocks? If analysts forward expectations can't be trusted? If operating earnings are simply wishful thinking? If reported earnings are telling us that stocks are worth nearly nothing?

I don't know. But I do know what one shouldn't do. One shouldn't simply ignore the fact that asset deflation is having the same effect on public companies as it is on private individuals. One shouldn't buy common stock thinking "well I know this company isn't going to disappear." Indeed, the company may stay around, but as a stockholder you could get a Goose-Egg while you watch the creditors reorganize the company.

It seems that many have very little understanding of corporate structures. Your claims as a shareholder and your claims as a bondholder are completely different. Therefore the statement "Coca-Cola is going bankrupt" does not imply that their product disappears from store shelves and lives only in our memories henceforth.

In my opinion, we are embarking on a period where those companies with low enough debt levels are separated from those with too much. The total equity of an index like the S&P 500 could indeed fall 80% from current levels in order to reflect the complete elimination of equity in many component companies. I don't know how long this would take to transpire, but could imagine that once a few precedents are set (such as GM), stockholders would be quick to realize their place in line. A panic out of common stock and into senior debt could ensue.

I can even envision a period of "predatory bankruptcies." A scenario where creditors see an opportunity in exercising their legal rights to accelerate bankruptcy in order to take control of the entire company, restructure it under private management, and issue shares to the public again once the economy has rebounded. Large profits could be had if the timing was right - and in most circumstances this would be perfectly legal.

Being long common equity could prove disastrous for those simply betting on long-term survival. But you might be able to squeeze out another 20% on the upside. Do you feel lucky?

Earnings season is again upon us. I do think it is quite possible that we see a pause in many of the major financial losses as a result of the FASB accounting tricks and the general rally into quarter end. But non-financial losses could continue to accelerate. The -$23 earnings quarter will probably prove to be the worst. However, I wouldn't rule out the possibility of seeing numerous consecutive quarters where earnings are barely positive or negative. Earnings conference calls should be particularly interesting this quarter. The analysts are expecting better than $8/share for the index. Any wagers on how they do? Leave your prediction in the comments below. The winner gets bragging rights.

My guess is $10.

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Namke von Federlein said...

Nice blog post! It reminds me of the good old dotcom days. Back then I was joking : inflation isn't dead - it's alive and well and living in the stock market.

Basic principle of capitalism : equity absolutely must out-perform debt. Which is why I think that your post today is so important. Equity is now under-performing debt.

Did you catch my blog post about the marginal productivity of debt (from the Financial Sense web site)? That's what is happening right now. The multiplier of issuing new debt is negative.

Last year I was blogging an outrageous idea - that the US dollar is worth *less* than nothing - which would lead to a huge *pricing* problem.

And now we have it in the US stock market. There is no way to price stocks (or anything else) in US dollars. No realistic way to price commodities and *no realistic way to price debt*!

So, we are now in stock market fantasy land. Market to market is being 'adjusted', P/Es are *inflating* (get it?) and all the money piles up in cash paying *less* than nothing (adjusted for inflation).

Why? Because there is not one profitable business in the US now. Why? Because there is not one *productive* business in the US. They are all carrying long-term debt at old rates (8-10%) and they cannot improve their productivity fast enough in a year (8-10%) to get back to zero!

Which makes your point beautifully - they are all vulture take-over targets. They have to a) go DIP bankrupt and restructure (stripping out the pension liabilities and the old debt rates) or b) get vultured (stripping out the pension liabilities and selling off assets to pay of old debt to get the debt carry cost to zero).

Did you catch the problem? All the money that hard-working people paid over decades into the pension funds is going to get fried. Ouch. How do you think that this will affect employee motivation and productivity?

Even as consumer and business spending falls through the floor.

So, to answer your question about earnings : it is not a question! They will make up what ever nice numbers they want. Do you know how?

A tax write-off is an asset and so is goodwill. With no mark-to-market. Use the three together and the earnings will be whatever looks nice as a center-piece on the table.

So, I will predict exactly $ 9.28 - if I ran the S&P I would just let everybody know in advance that this is their number.

Nice enough as a number? We'll see how close I get based only on 'happy world what would be nice to have'.

Fish10 said...

Well lets do the Math Matt.

$10 x 15 = S and P of 150.

Is that what you are forecasting?

Fish10 said...

BTW Matt thee are two types of businesses in Canada.

Small ones which are allowed to go bankrupt when they make bad decisions, and big ones with good family connections which are bailed out when they fail:

freddyv said...

My prediction is -$12.00 for Q1 and -$47 for the year. Then they can TRUTHFULLY say that P/E's are no longer relevant because you can't figure a P/E ratio (in any sensible way) using negative earnings. Well, at least when I try to figure it out it feels like my brain is going to explode. :-)

Matt Stiles said...


Yes, I got the Fekete article. It was a good one. Thanks.


No, that was just one quarter of earnings. You have to add the previous 4 quarters and multiply by the P/E you expect to get the projected S&P.

Thanks for the link. I'm e-mailing my MP too. That is outrageous.

Anonymous said...

The stock market is headed for the Zimbabwe model. Senior debt will head towards a SDR reserve currency compensation exit and once the deflationary cycle is halted and the inflationary run up proves to be uncontrollable by to the FED/Treasury, the common stock holdings will explode a la the Zimbabewe stock market run of 2006 / 2007.

...and then we will go to war for real.

Anonymous said...

Brilliant and Thank you!
Have been trying to manage my own investments since my Husband died. You just shined a bright light for me.

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