What P/E of 10 means

We see a lot of talk whether the market will go lower, higher, etc. Let's abstract from this and try to take a view of an accountant and think about earnings that accrue to an investor, as opposed to stock prices as such.

Let's say that you invest money in a stock index, made up of various businesses, that sells for a P/E of 10.

For every 10 dollars that you invest, the companies would make 1 dollar (you can call it look through earnings). Assume that they would pay you one third, or 33 cents dividends. That means that you could own 3.33% more shares just by reinvesting dividends (somewhat less due to taxes, more like 1.8% or some such). Then, let's say that the businesses repurchase their own shares using 33.3 cents out of that dollar. That means that each share now would earn 3.33% more. No dividend tax accrues from that. And let's say that they invest remaining 33.3 cents to grow, so next year they have 3.33% more capital.

So after one such year, your earnings that accrue to the companies you own, would grow by 10 cents or 10 percent. And next year. So what you have is a volatile money making machine that, over time, could earn you 10 percent a year without any upward adjustment to P/E.

If such an adjustment occurs, as it happens, you would be looking at major gains.

This math, by the way, changes dramatically for the worse as the P/E ratios go higher. At P/E of 20, your look through earnings can grow by only 5% per year, and that is not nearly as much upside.

At P/E of 25, the stocks are outright not worth owning.

But as of now, there is relatively little risk of owning stocks if you can hold on to them for 10 years or more.

As of last wednesday or so, I moved my, my wife's 401k into stocks and did same with my 7 year old UTMA account at Vanguard. My wife was 100% in cash prior, I was 80% in cash prior, and so was the kid.

Reply to
Igor Chudov
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Reply to
Igor Chudov

P/E is a tricky thing. They change as much due to earnings not keeping up with price as they do due to earnings just going south. A low P/E implies there are risks which are pushing the price down (think Philip Morris some years back) or pushing the price up to reflect a higher P/E (as some tech companies which actually have a product and real growth). Ken Fisher's "The Only Three Questions That Count" dispels the myth that one can succeed simply by focusing on low P/E stocks.

Joe

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Reply to
JoeTaxpayer

Probably not even that long.

P/E ratios reflect price and that can be misleading.

Return on equity is the basic measure of how well companies are doing and how fast they can grow. If a company pays out high dividends or buys back stock, they will not be able to grow as quickly.

Good idea.

-- Ron

Reply to
Ron Peterson

Joe, I think tat what you said is very insightful when applied to individual stocks. But when we talk about the P/E ration of the aggregate of stocks, things become very different. For example, it would be a stretch to think that expectations of their long term earnings, taken in aggregate, would wildly change with various short term economic events.

Reply to
Igor Chudov

You might like to read this:

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It talks about the divergence between bottom-up company analysts estimates (many of which are as yet not updated to reflect the current economic situation) versus the top-down projections of some economists regarding future earnings.

Talk about out of touch: Analysts currently estimate that earnings for the companies in the S&P 500 will rise 29% in the fourth quarter, and keep climbing, by 15% in 2009, to a record $91.41 a share, according to Thomson Reuters.

To get a better fix on what lies ahead, forget the analysts and pay attention to Wall Street strategists, who spend their time looking at the overall market, not individual companies. The strategists tend to place greater importance on economic growth and employment patterns in formulating their earnings predictions. Five prominent strategists we polled last week expect earnings for the S&P 500 to fall 15% this year and 3% next year, to roughly $70 a share.

If you believe them - $70/sh earnings next year, with the S&P at about 960, you're looking at 13.7 p/e ratio.

Which is pretty much right around the average long-term ratio against *expected* earnings over the last 30 years.

Read into it what you like...

Reply to
BreadWithSpam

I think that a number that is more objective than what the analysts and strategists are discussing, would be past earnings. Perhaps companies would make less next year, but assuming that the economy recovers, earnings would be more or less at the level that they were.

Reply to
Igor Chudov

John Bogle, founder of Vanguard, seems to agree with me, up to the numbers.

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U.S. market has "improved radically": Bogle Tue Nov 4, 2008 5:37pm EST

By Jason Szep

BOSTON (Reuters) - The fundamentals of the U.S. stock market have "improved radically" and declines in valuations to five-year lows are overblown, legendary investor and Vanguard Group founder John Bogle said on Tuesday.

Bogle's comments, coming as U.S. stocks rose in their biggest Election Day rally, underlines an emerging streak of optimism on Wall Street over corporate earnings and the prospect of more measures to prevent the financial crisis from turning into a global recession.

"It seems to me that people have lost sight of the fact that the fundamentals have improved radically," said Bogle, who launched the colossal $97 billion Vanguard 500 Index VFINX.O in the mid-1970s as a low-cost investment strategy.

The hard-charging, 79-year-old founder of the nation's second-largest largest mutual fund company said he expected the earnings of companies in the Standard & Poor's 500 Index .SPX to grow at a rate of about 7 percent annually over the next decade.

That should pave the way for returns on U.S. stocks of around 10 percent, according to his calculations that combine a projected earnings growth rate with a three percent dividend yield generated by stocks in the S&P-500 Index.

"The value of the U.S. stock market was $18 trillion a year ago. And now it's about $9.5 trillion or let's call it $10 trillion with today's rally. Anyone who believes that American business is worth $8 trillion less than it was a year ago I think is a fool," he told Reuters in a telephone interview.

"Will it be worth a lot less than that and the market is anticipating it is a reasonable question," he added. "Was it somewhat overvalued at the start is an even more reasonable question, one which I would answer in the affirmative.

'HOT AIR IN THE SYSTEM'

"So there was some water in the system, some hot air in the system, and we blew it out, but I think we have overblown it," he said.

Bogle left the Vanguard helm after a 1996 heart transplant, and now often castigates the mutual fund industry as a marketing vehicle run not so much by investment professionals on behalf of investors as by short-term minded entrepreneurs.

"Institutional money managers, including the managers at mutual funds, have a lot to answer for," he said.

"If they were professional security analysts, where were they when they looked at the balance sheets of those banks?" he said in reference to banks that took huge write-downs for their exposure to losses in subprime mortgages that snowballed into the worst financial crisis since the 1930s.

"They joined the speculative frenzy, turning over stocks 100 percent a year. It has nothing to do with investing. It's a great big marketing business," he said.

Bogle, who maintains an office in the same building as Vanguard's executive suite on the company's sprawling suburban campus near Philadelphia, said he had no plans to reduce his busy workload as a vocal critic of industry excesses even as he approaches his 80th birthday in May.

His latest book, "Enough: The True Measures of Money, Business, and Life", hits store shelves next week. He maintains a hectic schedule of delivering speeches and appearances on national media. And he runs the Bogle Financial Markets Research Center, which consists of him and three assistants.

"I live life one day at a time," he said. "When my mind gets bad, I hope that somebody, my wife maybe or somebody here, will say 'you are not the man you used to be'."

"And, of course, I'm not in terms of physical strength and endurance and all that. But I think in terms of moral strength, writing strength, intellectual strength, I am as good as I am going to get," he added.

(Editing by Leslie Gevirtz)

Reply to
Igor Chudov

Selecting individual stocks has many advantages over buying indexes and funds. So, not trying to make you wrong, but asking logically -

- stock buybacks are often a cover for options expenses?

- how does 33% of EPS translate into 3% of capital?

- if earnings do not increase, why not buy bonds?

I can see 10% increases, but I'm not sure I see your numbers producing that. As others here point out, ROE and the earnings part of PE are very material.

Nice article. Bogle does make some pertinent comments about funds falling asleep buying banks, but the blame there should also go to materially immaterial SEC filings. It is critical to have exactly accurate financial reporting. Referring back to an earlier topic about deregulation, I think the FASB site covers the deregulation that allowed this mess - I have yet to brace myself to try to read FAS 140, but that may be the reg (actually it's not a regulation, technically) that facilitated off-balance-sheet items. I was surprised at how easy it is - if the bank has no direct management of a business, it is allowed to put it into a trust, and a trust qualifies for "off-balance- sheet" treatment.

Still, it is amazing that one well-known and highly regarded stock fund had over 16% of its total assets in financial stocks (over $8,000,000,000)(eight billion dollars). Wouldn't you think that for that amount of money, they could afford to hire a cracker-jack accountant, and give him a phone line to the financial companies they put that money into? And that he would think to call to ask where the excess returns were coming from? That's just basic Buffett. < If you don't understand it, you shouldn't put money into it. >

My opinion is the "smart guys" rely on making us think they are very very smart ... but how smart is it for a nearly trillion dollar bank to write off tens of billions of dollars in losses, go belly up, and sell itself for pennies on the dollar? Time for those jerks to "lawyer up." A lot of people are really very angry about this 'stuff'.

Reply to
dapperdobbs

Absolutely. It also has some disadvantages. Some disadvantages are

1) Cost of trading 2) Cost of time spent researching 3) It is not at all easy to pick up "winning stocks", as stocks of companies with great prospects are usually not cheap.

Stock options are now expensed, per GAAP.

Good question. I think that for the S&P as a whole, it trades at about

1.6 times book value. This gives about 16% return on equity. Since there is some debt held by S&P companies, return on assets is lower, I do not know what it is, but assuming it is 10%, additional retained capital would return about same 10%.

Do bonds return 10% per annum?

I agree, but now the financial stocks are traded with all that information priced in.

Reply to
Igor Chudov

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