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P/E

I think you meant "earnings" when you typed "dividends" - they're quite different - but regardless, understanding what P/E is reported makes this all a bit clearer.

Most quote services, and most "index P/Es" that you see reported, are based on the trailing twelve months of reported earnings ("TTM"). The P/E is looking in the rear view mirror. In say early-mid 2008 the trailing P/E for a broad-market stock index might still have included in its earnings the past income of soon-to-be-defunct-or-acquired companies like Lehman, AIG, Fannie Mae, WaMu, Countrywide, Merrill Lynch and on and on. Earnings were clearly contracting but the "E" that was the basis for the market P/E hadn't yet adjusted, because it hadn't hit the next reporting quarter yet.

So it makes perfect sense that P/Es will rise and fall over time. Price is responding to the expectations for what earnings are going to be in the future. I'd add the nuance that inflation is a factor here too, because that affects the price you'd pay for earnings ($1 a share next year is worth less to you if inflation is 100% per year - so would demand a lower P/E).

But anyway - if the market is doing a good job of predicting the future, P/Es should be below-average when earnings are about to drop (or "not grow much"), and should be above-average when earnings are about to rise, simply because of the P/E that's reported (TTM). Only if earnings were always stable should P/E be stable, or perhaps stable when you adjust everything for inflation. And earnings are never stable!

You can find examples where the market is right about individual stocks

- P/Es of 2, 3, 5 right before bankruptcies or big declines in earnings. Of course you can also find examples going very strongly the other way, which gets at the argument that "value" - whether expressed as a low P/E, a low price relative to book value, or a high dividend yield - is just signaling some type of risk, and risk and reward should be related.

-Tad

Reply to
Tad Borek
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Can you explain why earnings are fundamental? I try to buy low P/E stocks, but then, sometimes, the earnings disappear and the stock drops.

Why aren't sales fundamental since earnings are usually less than sales?

-- Ron

Reply to
Ron Peterson

Ron -

Yes ... the valuable product or service underlies the sales, then profit margin determines the earnings. In pretty much all companies, there are fixed costs and variable costs (micro-economics). The idea is to keep total costs below the total sales, thus generating a profit. (I just skipped directly to earnings, on the assumption that these demonstrate that the company is well-managed and has a good diversified product line.) In securities analysis, you want a company with demonstrated capacity to generate earnings on a sustainable basis.

Thorough analysis will look at the accounting and micro-econ of the company, and of course some estimation of the market for the products, and some estimation of management competence in adjusting to new conditions. There's nothing wrong with horses and carriages, nor with many companies that manufactured them. But the automobile ate their lunch. Walmart is considered a fairly safe investment because they are the best at providing products people want to buy at the lowest prices. In a sense, it's a service company.

Usually, a history of steadily increasing earnings is a good enough guess that earnings will continue in the future. MacDonald's is a good recent case-in-point. Although a huge and mature company, in response to changing consumer preferences, they changed their product line rather dramatically, and apparently, very successfully. Their methodology or researching new line-ups is very interesting, and relevant.

Benjamin Graham and Peter Lynch are good reading for analysis and investing. It isn't necessary to delve into graduate level micro-econ

- I know, I've done that, and I do not use the analysis (it's too fine, too much for company use in fine-tuning). I just look at consistent earnings and a solid market for the products and services, coupled with at least decent management. One indication of good management is a gradually increasing return on equity, or similar measures such as return on invested capital, etc., and conversely, declining measures may be an early indication that something is not going well.

But yes, you are right. Earnings are the bottom line reflection. More fundamental are the product or service, the determination of those, and then the marketing, financial, and other management functions.

- George.

Reply to
dapperdobbs

Stocks are cheap now compared to last year, but you shouldn't judge stocks based on recent prices. You should look at fundamental values. PE ratio can be used to guess this, but company earnings can fall.

Reply to
norak

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