Doug Flynn, CFP of Flynn Zito Capital Management, LLC, on the P/E Ratio.
Doug: It's a great measure to determine - is it getting ahead of itself? You can use this for an individual stock, or just for the market overall, to determine where it is. Is it cheap, is it moderately priced, or is it expensive?
Ali: And that's when, when you hear people on TV shows say, "This stock is cheap, this stock is expensive," or the market is expensive, which is something that a lot of people are saying right now.
Doug: So if you go back from the initial boom in the late 90s into the top of 2000, you will see at the peak there the PE ratio, and really what the PE ratio is, is you take the price of the stock, and you take the earnings, and so simply if a stock has earning of a dollar per share, then if the stock is trading at $25, then the price relative to the earnings is 25.
Ali: So the PE ratio of that stock is 25?
Doug: Exactly, and that's peak you hit there in March of 2000. And so, the average in history past is about 18. If you're looking forward, it's about 16. So that's where people say 17 is a good number to think about. When you see a number like 25, that's way high, and that's when typically you see a drop, and you see exactly what happened after 2000, and a low point in 2002.
Ali: Fast-forward to October 9, 2007. That was a high-point in the Dow before the recession.
Ali: And we were at 17, so it wasn't a given that market was overpriced, even though it was going to go down for the following year.
Doug: That's right. And I might argue that that was purely related to the financial crisis, which sort-of side-stepped this. If you skip over, you're looking now, and your saying "Is the market over-valued?" Even though the market has run up a lot in percentage...
Ali: The PE is actually lower than it was in 2007.
Doug: It doesn't make it overpriced because it's related to the earnings. If the earning go up 100%, then the price can go up 100% and the multiple hasn't moved. Now that being said, if we continue on and the price keeps going and going and going, but the earnings stagnate, that's where the multiple's going to get out of whack, or too high, and you have to be concerned about where you're buying it.
Ali: So what do you do with this information?
Doug: What you do, whether you're looking at an individual security, or you have a large lump sum of cash, and you know the market's up after the lows of the financial crisis, and you ask, "Do I want to throw money at it?" You might say, "The market right now is reasonable priced." Going back to that chart, at the lows of 2009, it was on sale.
Ali: Right, and that has worn out. If you bought stocks in March of 2009, you have done phenomenally well. And that actually explains this fortification in our economy: those people who had money to buy stocks in 2009 have done so well.
Doug: That's right, and you have to disconnect, necessarily, the market from the economy sometimes. The market, when things are underpriced, are going to snap back and become reasonably priced; and that's where we are. Now people think it's overpriced because of where we were, but if you look at the multiple, at least in this measure, it's not overpriced...yet.
Ali: If we keep going on this trajectory, there might be a point when you come into me and say, "Alright, now we're trading at 18."
Doug: Yes, and 20's right where we really start to worry, and you say, "Maybe I won't just take a large sum of dollars and just throw it in the market at those multiples." Right now, its reasonable, you're not going to make as much money than had you done it a few years ago, but it's not like you're buying it overpriced, just yet.
Ali: We always pay attention to the P. This is why the E, the earnings, become important. I often talk about corporate earnings on the show, and I'm sure my viewers glaze over it because it can be boring, but the earning trend is the other side of this equation. If you constantly coming out and warning, or missing their earnings estimates, earning less than they did last year, that has to come into this equation.
Doug: Exactly, or if you see them on the flip side, if they unfortunately if they lay off people, a lot of times that translates into higher earnings because their costs go down. You say of course if I'm the person who got laid off that's terrible, but if I'm an investor in that company, and that company becomes leaner, and their corporate profits rise, that's how you make money, because the company's going to earn more.
Doug: Therefore can support a higher price, and this is what it's all about. Earnings over time drive the market, that is really what drives the market over the long-haul, that's why is not only really important to look at it now, but on an ongoing basis.