P/E Just Part Of Picture
When you hear statements about market valuation from financial pundits, they’re usually referring to price/earnings ratios. That’s not a bad thing — the price/earnings ratio is the best-known valuation metric, as well as one of the most effective. But the ratio itself only gives you a piece of the puzzle.
To assess whether “the market” is cheap, you should consider P/E ratios from several directions:
Relative to history. The capitalization-weighted S&P 500 Index trades at 20 times trailing operating earnings. That number alone does not tell you whether stocks are attractively valued. The current index P/E is higher than the average of 19 since 1989 and the average of 17 since 2004 but lower than the 25 seen from 1999 through 2003, a period when stock valuations at times reached dangerous heights.
Verdict: The S&P 500 Index, its trailing P/E lifted by an operating loss in the December quarter, looks somewhat expensive relative to historical norms. The P/E has been inflated by huge losses at the largest financial companies, and valuations often appear high during an earnings trough. Consensus estimates project per-share-profit growth of 32% for the index over the next 12 months, which seems high. But if the forecast proves accurate and the P/E reverts to the mean of 19 since 1989, the index would rise 30% over the next year. We are not necessarily projecting such strong gains, but the numbers illustrate that even if the index’s P/E ratio declines somewhat, an earnings recovery could lift stocks.
Index versus individual stocks. Because the S&P 500 is capitalization-weighted, the largest companies have an outsized effect on data for the index as a whole. Since 1990, the average S&P 500 stock has averaged a P/E ratio of 20.6, while the median stock has averaged 17.9.
Verdict: The average S&P 500 stock currently has a P/E ratio of 13.5, well below the 19-year norm. The median P/E of 12.0 is also substantially lower than the norm since 1990.
Quadrix scores: Quadrix® scores are percentile ranks, with 0 the worst and 100 the best. As the market changes over time, Quadrix scores don’t always reflect the same values. To earn a Quadrix score of 75 for trailing P/E ratio today, a stock must trade at 9.8 times earnings. However, at the time of the S&P 500 Index’s peak P/E ratio, back in June 1999, there were fewer stocks with low P/E ratios, and a ratio of 12.0 would earn a score of 75.
Verdict: Current P/Es are much lower than the average since 1990. For instance, the P/E ratio currently needed to earn a 75 is 18% lower than the 19-year average, while the value that earns a 50 is 17% below the historical norm. Today, there are enough cheap stocks that it requires a P/E ratio of 4.5 to earn a Quadrix score of 95, down 28% from the average of 7.1 since 1990.
Stocks versus bonds. One way to assess the relative value of stocks as an asset class is to compare the S&P 500’s earnings yield (earnings divided by price) to bond yields. Since 1989, the S&P 500’s earnings yield has averaged 5.4%, about 2.6% below the yield of Baa-rated corporate bonds. As of July 7, the index’s earnings yield was 4.9%, versus a yield of 7.2% for Baa-rated corporate bonds, for a spread of 2.3%.
Verdict: Relative to bonds, the S&P 500 Index is neither particularly cheap nor particularly pricey. The average S&P 500 stock is a different story — it looks cheap relative to bonds. The average stock’s earnings yield is 7.4%, 0.2% above corporate-bond yields. Since 1990, bond yields have averaged 2.8% higher than the average stock’s earnings yield.
What does all this mean to investors? While the S&P 500 Index as a whole is not cheap, much of the premium built into the P/E ratio is a result of extremely weak recent results. Thus, a decent earnings recovery would erase that premium quickly. Taken in total, the stock market appears to be somewhat cheap.
In addition, individual stocks seem attractively valued relative to their history. The average S&P 1500 Index component trades at a 30% discount to its five-year average P/E ratio.
The Forecasts puts a lot of stock in valuation, and many of our selections earn high Quadrix Value scores. Many valuation metrics and comparisons are useful for stock analysis, and our Value score is designed to reflect a number of valuation statistics. All of the stocks in the table below score at least 70 in Value and also trade at a discount of at least 10% to both historical and industry medians.
Accenture’s ($33; ACN) broad geographic and business mix has blunted the recession’s sharpest blows. May-quarter revenue for the Asia-Pacific region grew 10% at constant currency, though sales stalled elsewhere. Outsourcing sales rose 3% at constant currency, partially offsetting weakness in consulting, down 9%. While Accenture’s profits fell, they topped expectations, and the shares rose nearly 7% on the news.
Project deferrals and pricing pressure could continue until clients set their 2010 technology budgets. But the company is seeing some signs of the market stabilizing, and a 20% gain in outsourcing bookings in the May quarter suggests operating momentum should improve.
Accenture raised its profit target for the year ending August, and the consensus per-share-profit estimate has risen by 2% since the June 25 announcement. The stock trades at 10 times trailing earnings, a 42% discount to the five-year median P/E ratio of 17. Accenture is a Buy and a Long-Term Buy.
AstraZeneca ($43; AZN) looks cheap from multiple angles. The shares trade at nine times trailing earnings, 33% below the five-year median and 32% below the industry median. AstraZeneca also represents a good value relative to sales, cash flow, and book value, with all three valuation ratios at least 20% below their five-year medians.
AstraZeneca has grown steadily despite the recession. In the past 12 months, per-share profits climbed 15% on 6% higher sales. The consensus projects per-share profits will rise 12% in 2009.
Looking further out, the product pipeline includes about 60 drugs in Phase II clinical trials or beyond. The latest success story, Iressa, in June earned European Commission approval as a treatment for lung cancer. AstraZeneca’s strong pipeline represents a competitive advantage in a drug market where research productivity has declined. AstraZeneca is a Buy and a Long-Term Buy.
Energen ($36; EGN) has surged 24% this year but remains cheap compared to its history. The shares trade at a discount of at least 32% to their five-year median price/earnings, price/cash flow, and price/book ratios.
The company’s natural-gas utility (42% of revenue and 15% of profits in 2008) and aggressive hedging activity limit the effect of changes in energy prices on Energen’s results. Energen has locked in prices for more than 75% of expected production in the second half of 2009 and roughly 56% of 2010 production at prices well above current levels. For 2010, Energen’s hedges are set at $8.81 per thousand cubic feet of natural gas, versus the current price of $3.28 per thousand cubic feet.
While production is likely to rise about 4% this year, Wall Street anticipates per-share profits will fall 25%, hurt by lower energy prices. The consensus projects profits will jump 27% in 2010. Energen, slated to report June-quarter results July 22, is a Long-Term Buy.
General Dynamics ($52; GD) earns a Quadrix Value score of 93, ranking it among the top 7% of our Quadrix universe. Shares trade at nine times trailing earnings, 48% below the five-year median. A return to that historical average P/E would push the stock above $90 by the end of this year. While such an advance is unlikely, the P/E multiple should expand in coming quarters as the prospects for aerospace improve.
The company’s two largest business units, military equipment and corporate jets, have investors jittery. But concerns regarding both could be overblown. As the fourth-largest Pentagon contractor based on sales, General Dynamics sees a lot of upside potential in the Marine (19% of 12-month sales) and Information Systems (34%) segments. General Dynamics is a Buy and a Long-Term Buy.