Wednesday, February 27, 2008

Low PE Means the Stock is Cheap?

Came upon this interesting posting, Do low multiples mean the market is undervalued?

Posted almost a week ago, Mr. Turley pointed out the following fact.

  • S&P 500 is trading at low price multiple to expected earnings, 13.7 according to WSJ. The historical forward P/E has been in the range of 14-16, depending on how far you look back. With interest rates incredibly low, 3.88% on the 10-year, should make the fair-value multiple even higher.

    According to my calculations, the S&P 500’s mean P/E = 14.2 and median = 13.2. Thirteen companies were excluded due to negative earnings. The highest P/E was 90, and only ten firms had multiples greater than 30. The chart shows the frequency distribution of the individual firm’s P/Es constituting the index.

    So is the market cheap? The low price multiples suggest that it is.

I like the way Mr. Turley argues against this notion.

  • In my opinion, that magnitude of growth is wildly optimistic. The Market isn’t buying it either. It’s not that the market is cheap, it’s that investors believe consensus estimates are too high. Why do I think that? Because if the market had full confidence in the forecasted numbers, I doubt the market would trade at these multiples. Hence, investors are pricing in lower earnings than the consensus forecasts thus making multiples higher.

And Mr. Turley continues

  • In my opinion, stocks are not as cheap as forward multiples suggest. Earnings estimates are too high and are likely to come down. In addition, the ERP has increased pinching multiples. However, if the economic slowdown begins to appear less severe as the Market is expecting, then stocks would be rather cheap. That would mean that analysts are not overestimating future earnings. However, given the turmoil in the housing market and the relationship to consumer spending, it’s likely the coming quarters will be weak.

When one uses forward multiples, stocks can always appear cheap when the earnings estimates are too high caused by wildly optimistic growth projections!

And I can certainly see it around us here. The way our local analyst projects earnings estimates is as if growth grew on trees!

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