P/E Multiples Reveal Attractive Stock Prices
December 8, 2008
Many investors are looking for direction right now, as the U.S economy trouble intensifies and the bear market gets brutal. After the U.S. economy contracted a seasonally adjusted 0.5 percent annual rate in the third quarter of 2008, the National Bureau of Economic Research (NBER) finally declared on December 1 that the U.S. economy has been officially in recession since December 2007. The economy is forecasted to keep shrinking until the early next year.
As the economy shrank, the bear stock markets are getting brutal with S&P 500 index crashing through its 2002 bear-market low to 752.44 on November 20. By touching its lowest level in more than 11 years, since April 14, 1997, the S&P 500 index removed more than a decade of stock market gains and made the current bear the second biggest bear market on record. At this point, the S&P 500 has lost more than 40 since its peak in October 2007.
The cruel bear has caused investors panic and lost direction where the stock market is heading. The market fear is reflected on the market's expected volatility measured by the CBOE volatility index, which hovers above 60 mark after hitting unprecedented high closing mark of 80.86 on November 20.
A question for value investors is whether the stocks have been under priced or not. Price-earnings ratio, or P/E, is one of popular tools for investors to value stocks or stock indices, whether their prices are cheap, expensive, or fairly valued.
The average trailing P/E for S&P 500 since 1935 is 15.8, but in the past 25 years the average P/E is above 20 due to higher stock valuations in recent decades.
At the December 5 closing price of 876.07, the companies in the S&P 500 are trading at 10 times 2009 S&P earning estimate of $87.20 a share. This forward P/E ratio of 10 means investors are willing to pay $10 for every dollar that analysts expect companies to earn in 2009. Because that ratio historically falls in between 15 to 20, the current P/E indicates that the market seems cheap by most historical comparison.
That forward P/E includes some assumptions about where earnings are heading in the next year based on consensus S&P earnings estimates for calendar year 2009 provided by the Thomson Reuters. The low forward P/E essentially has priced a lot of potential earnings fall and thus provides a large space for earnings to drop. At the current index price, the earnings still could tumble 33 percent from their estimates to $58.40 to bring P/E ratios in line with their long term average of 15.
In another scenario, if the earnings are correctly predicted at $87.20, the low P/E provides a lot of room for stock price increase. The cheap stock valuation would be able to provide 15 percent gain to cause the P/E multiples to get back on their long term average track.
Just because something is cheap doesn't mean it's a bargain. The broader stock market's recent momentum is horribly risky with unparalleled high volatility. The CBOE volatility index shows the implied volatility of 60s.
For investors with long time horizon and stomachs to handle a wild ride, P/E's indicate stocks are attractively priced and now it is a good time to buy. Investors should start buying smaller sums steadily over time, not necessary rapidly, when stocks are cheap while saving some power in case the market collapses in its way to reach the bottom. This will allow investors to participate in some upsides, while protecting them from a big downside. No one can time the market and predict the bottom.
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