Reuters Editor-in-Charge of U.S. Markets David Gaffen gives us a summary of how to use price-to-earnings ratio trends to better understand a company’s stock value:
The share price effectively acts as a way of discounting future earnings, so the price-to-earnings ratio suggests whether a company or index is expensive or not. Sometimes, this P/E ratio expands, i.e., the ratio grows. If the price is rising faster than earnings increase, it reflects optimism that things in the economy and for earnings are going well. If it the ratio expands because the price is stagnant and earnings are declining, it’s a sign that investors aren’t willing to push stocks higher because earnings are falling, and if it goes into an area considered expensive, investors would “re-value” the stock, that is, sell it until it becomes more fairly valued.
Valuation figures would suggest that the S&P 500, now at an all-time record (boy, everyone was real worried about the default there!), isn’t particularly expensive, trading with a forward price-to-earnings ratio of 14.5 times, a shade below the long-term average of 14.85. With that as a starting point, earnings season should be watched closely for signs that any appreciation in stock prices is warranted, or whether equities could go into a steady period of churning without much in the way of gains.
For if earnings expectations need to keep coming down, as Reuters reporters Rodrigo Campos and Julia Edwards pointed out in a story Thursday, that’s going to cause expansion in price-to-earnings ratios in the way you don’t want: lower E, not higher P.
Tobias Levkovich, chief strategist at Citigroup, said 2014 earnings estimates have to come down. At 11 percent, they’re way too frothy, he said, pointing to cyclical sectors that have priced in a lot of appreciation already, particularly materials, industrials, discretionary and health care stocks.
One measure of how companies are doing relates to their profit margins before factoring in taxes and interest paid, butseveral sectors have been pretty lousy on this front: industrials, energy, tech, and materials have seen sharp declines in profit margins in the second quarter of 2013, according to Goldman Sachs, and as more bellwethers report, starting with General Electric and Honeywell on Friday, a sharp eye should be kept on this as one key gauge of health.
IBM has been the poster child for the margin decline seen by tech companies. Margins on its earnings before interest and taxes fell to 17.8 percent for the first nine months of 2013, down from 19.2 percent in 2012. Why focus on profit margins? This measure pulls out the different tax brackets and capital structures at different kinds of companies. For example, IBM had a favorable shift in taxes this quarter, muddying the results.
Google, to take another example, posted a margin of 26.1 percent for the first nine months of 2012; for 2013, that margin has dropped to 23.4 percent. The saving grace for glorified ad company Google is that the Google is increasing revenue and plowing more money into expenses.
IBM, on the other hand, saw profits drop by more than $3 billion in the first nine months of 2013. So it was able to beat on earnings, albeit with lower margins, while missing on revenue.
Which has kind of been the story for some time: The industrials sector got going on Friday, and Honeywell is doing well from this perspective, with margins rising to 14.7 percent in the first nine months of 2013, from 13.8 percent for the first nine months of 2012. A handful of others come in next week, including Caterpillar. That company’s EBIT figure for first-half 2013 was 9.9 percent, down from 14.8 percent in 2012. That’s not a good trend.
"Future index returns will depend on growth in book value, which is another way of saying that the valuation expansion phase of this market cycle is largely behind us," Goldman wrote.
Want to learn more? You can follow David on Twitter @davidgaffen and visit David’s blog at Reuters. A portion of this content will also appear on Reuters Counterparties newsletter. Photo by REUTERS/Brendan McDermid.
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