P/E

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.

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.

I don't get this at all. The price of a company's share of stock is what people are willing to pay for it. It has nothing to do with $1 worth of dividends in the future. Am I missing something?

She defined P/E above, not the actual price. Aside from that (minor) mis-speak, I liked Elizabeth's post.

Joe

On Dec 31, 6:35 pm, "Gil Faver"

Hmm . . . P/E has nothing to do with dividends, either.

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

"Gil Faver" > which a buyer is willing to pay for $1 worth of dividends in the future;

I agree with you. The current price of a stock is set by supply and demand. More supply means a lower price and more demand means a higher price.

The vast majority of stocks have a price that has nothing to do with discounted cash flows based on future earnings or dividends.

If someone needs cash now they sell their stock now without caring about future earnings or dividends.

One of the classic problems for value investors is that a value stock can stay a value stock for years or decades. Just because you see or calculate value in a stock does not mean that the market will ever see value in that stock.

Can you please give your definition of a value stock? I always thought that a value stock staying a value stock could be a perfectly good thing. Their share prices tend to keep up with the S&P 500 and with the re-invested higher than average dividends, the compounding effect inter alia justifies this investing approach.

Thanks for the explanation,. So the retained earnings only increase the book value which has wierd stuff like goodwill. So it seems the expected price increase due to retained earnings would have to be worked out on a case by case basis. Bummer.

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The "gotcha" is an accurate description of earnings. You have to read annual reports closely to evaluate the company. There was a time not too long ago when accountants shirked there duty and puffed up earnings. This lead to greater accounting regulation. Now its perhaps the other way around - companies will take special charges at a drop of a hat. You have to add these back in for a truer picture.

Classic definition of a value stock is when the price of the stock is below tangible book value per share. The ideal value stock is when the price of the stock is below the net cash per share.

Modern definition of a value stock is when the price of the stock is low relative to tangible book value when compared with the average stock.

A value stock might not pay dividends and might underperform the S&P 500 for years.

Are these definitions off the top of your head? Or have you a citation for them?

I lean towards investopedia's definition, among others, which is different enough from yours that it bears noting:

A growth stock might underperform the S&P 500 for years as well. I am not seeing the "classic problem" you claim for value investors. Indeed it flies in the face of much historical evidence supporting value investing as a excellent strategy.

"Gil Faver"

I have to think you put up a great post. You reflect sanity that made America great, and sanity that will make the future.

People now buy "growth" companies with the expectation of capital appreciation in the price of the stock. Apparently this shift in expectations away from dividends, and towards capital appreciation, prevails near the beginnings of bull markets. And probably shifts back to dividends during and after bear markets. A lot of stocks rose very quickly in the 2000 electronics / internet bubble, but their prices got way ahead of any earnings. Thus, the high PE ratios.

The fundamental is earnings. One would think that this is very obvious. It is after all a tautology: the profits of a company make money. One would think that everyone certainly understands that. Surprisingly, it is difficult to get the point across. You've made about as succinct a statement for it as I have seen. Reminds me of Ayn Rand.

Sanity is the fundamental underlying earnings (product). We might have easily avoided the current mess.

- George