LEXIS®-NEXIS® Academic Universe

February 24, 1998, Tuesday, Home Edition

SECTION: Business; Part D; Page 1; Financial Desk

LENGTH: 2213 words

HEADLINE: STREET STRATEGIES / WALTER HAMILTON;
HOW TO KNOW WHAT A STOCK'S P/E FIGURE IS TELLING YOU

BYLINE: WALTER HAMILTON

BODY:
      Of all the lessons about stock-buying that have been handed down to individual investors over the years, few have been drilled into them more relentlessly than the one about price-to-earnings ratios.

The age-old advice is simple: Pay attention to P/Es and do exactly what they tell you. In other words, buy stocks with low P/Es and be wary of high multiples.

As a very general rule, that advice is probably OK. The P/E shows how expensive a stock is in relation to its per-share earnings, an obviously important consideration because profits drive stock prices in the long run.

The problem with all those supposedly sacrosanct teachings, however, is that they oversimplify P/Es and fail to explain how--and sometimes even if--you should pay attention to them.

Ever hear of Microsoft (ticker symbol: MSFT), or Wal-Mart (WMT)? How about Lucent Technologies (LU) or Coca-Cola (KO)? All are high-P/E stocks that have had fantastic gains. Investors clinging to low P/E strategies would have missed them.

Sentiment toward P/Es depends in part on which of the two broad investment philosophies someone follows: value or growth. Value investors hunt for cheap stocks and swear by low P/Es. Growth players, on the other hand, don't mind high P/Es because they're willing to pay up for rapidly rising earnings.

Here's the bottom line: P/Es help in assessing whether one stock is more expensive than another, but they're never the force driving stocks up or down. Indeed, a stock with a high P/E can keep going up as long as its earnings come through. And a low P/E doesn't protect a stock from dropping if the company's profits disappoint investors.

"The problem with valuation is it's a really lousy timing tool," said Marc Greenberg, a money manager at Avatar Associates in New York. "Stocks can be expensive for a long time. And stocks can stay cheap forever."

Adds Mark Specker, an analyst at SoundView Financial Group: "The astute investor will look far deeper than the P/E."

*

How can you use the P/E to judge whether a stock is worth buying or holding--or whether it should be sold?

Start by gaining a better understanding of how P/Es are calculated.

Far from being any single number, P/Es come in lots of varieties. There are trailing, forward, relative and historical P/Es. No single one is right or wrong to use; professional investors use different ones for different reasons.

Basically, a P/E is derived by taking the price of a stock and dividing that number by the company's annual earnings per share, or EPS. If, for example, a stock trades for $ 50 and its EPS is $ 2, its P/E is 25.

P/Es let investors determine how costly one stock is compared with another. The $ 50 stock with the 25 P/E is said to be "cheaper" than a $ 25 stock with a 50 P/E.

One of the first questions investors must ask when looking at a P/E is whether the figure is trailing or forward. Trailing P/Es take the earnings of the last four quarters or the last fiscal year. Forward P/Es use the expected profit over the next four quarters or coming fiscal year.

Many analysts use forward earnings, figuring that a company's past performance is already reflected in its stock price. Their reasoning: At its core, stock investing means deciding how much you'll pay today for what you expect a company to earn tomorrow.

That's what forward P/Es do, analysts say. Take the hypothetical $ 50 stock. Imagine the $ 2 EPS was a trailing number. If that figure is expected to rise to $ 4 over the next year, the forward P/E is 12.5.

"Of all the P/E figures to look at, the most important is the forward P/E," said Jeff Applegate, market strategist at Lehman Bros. "At the end of the day, the trailing P/E is history."

*

Critics, however, say trailing P/Es are better to use in judging stocks because they are based on profit a company has already notched. Estimated P/Es may or may not be realistic if the estimated earnings aren't achieved.

"I'd never buy a stock based solely on next year's expected earnings, because Wall Street analysts fall in love with their stocks," making overly bullish projections because they root for the companies they cover, said Mike Berry, manager of the Heartland Mid Cap Value fund.

The key point is that the forward P/E of a company with rising earnings will be lower than the trailing P/E--thus making the stock appear cheaper. Lucent's trailing P/E, for example, is a stratospheric 146. But its forward P/E is a more reasonable 35.

(If you're a mutual fund investor looking into the average P/E of your fund's holdings, ask if that figure is trailing or forward. Some fund companies that use trailing figures complain that rivals use forward numbers to make their P/Es look misleadingly low.)

There's another issue in judging trailing P/Es: The investor must determine whether that figure is based on operating earnings--which exclude one-time items such as write-offs--or net earnings, which include one-time items.

This difference explains why P/Es can vary in newspaper stock listings. Most papers publish trailing P/Es. But the Associated Press, whose numbers are used by The Times, generally excludes one-time items in calculating P/Es, whereas some other papers include them. So if a company had a write-off, its P/E in The Times would be lower than in some other papers, because the earnings number would be higher.

For example, say a company has a stock price of $ 12. Its operating earnings are $ 4 a share. But because of a $ 2 a share write-off, its net earnings are $ 2. The P/E on the operating earnings is 3 (12 divided by 4). But the P/E on net earnings is 6 (12 divided by 2).

Fans of net earnings say that number portrays a company's true results. Those who favor operating profits say that figure eliminates events that cloud the big picture.

But delineating operating earnings is far more subjective because it's not always clear what data to include and what to leave out. That's why Wall Street firms using only operating numbers sometimes have different figures among themselves.

*

Whichever P/E calculation you use in judging a stock, the next issue is deciding whether the multiple makes the stock expensive, fairly priced, or cheap.

P/Es shouldn't be looked at in absolute terms, many experts say. That Ford Motor's forward P/E is 10 while Microsoft's is 25 doesn't mean that much. They're in two different industries and have vastly different prospects.

Assessing a stock's P/E against the broad market P/E is questionable for the same reason. It's a bit like comparing apples to oranges.

Here's a widely accepted rule of thumb when judging P/Es: Many investors don't want to pay a multiple that is higher than the company's estimated annual earnings growth rate. That's what is known as the P/E-to-growth, or PEG, ratio.

A PEG of less than 1 is generally desirable. So a technology stock may be undervalued if its P/E is 40 but its earnings are growing 50% a year.

Going one step further, some investors study historical P/Es, comparing the current multiple against its past range. For example, a stock may be overpriced if it now trades for 30 times earnings and has changed hands at 20 in the past. Or it may be underpriced, if it historically traded at a 40 P/E.

To see how this works, consider HBO & Co. (HBOC), a large health-care software firm. Earnings are projected to rise 35% this year. The stock's forward P/E is almost 43. On the surface, the stock looks at least fairly valued if not overpriced.

But to Steven Halper, an analyst at Donaldson, Lufkin & Jenrette Securities, HBO is undervalued. In the last several years, the stock has traded for as much as a 50% premium to its growth rate because investors have paid up for its surging profits, he said. He thinks the P/E will again expand to its historical premium.

"That kind of growth rate deserves a premium multiple," Halper said. "It's not cheap. It's not for value investors. But this company is executing a tremendous business plan in a high-growth industry."

Adds Mark Toledo, chief investment officer of Mesirow Asset Management in Chicago: "The key to being a successful investor is to identify stocks that are starting to deliver on their higher earnings expectations so the market starts to reward them with higher price/earnings ratios."

Many investors also look at a stock's P/E relative to its industry.

"We'll look at a company's relative P/E within an economic sector, such as health-care stocks to each other," said Allan Rudnick, chief investment officer at Kayne Anderson Investment Management in Los Angeles.

Comparing P/Es relative to their industries works best in the case of companies with stable earnings, such as consumer growth stocks, experts say. But they can be misleading with cyclical companies, whose earnings gyrate with the state of the economy, said Ed Larsen, chief equity officer at AIM Investment Management in Houston.

With a cyclical company, its earnings may be high--and thus its P/E low--at the peak of the economic cycle. Just as its P/E bottoms, its earnings peak.

Using P/Es "makes some sense for growth companies or stable companies and very little sense for cyclical stocks," Larsen said. These days, no company exemplifies high P/Es more than Coke, whose 41 forward P/E is about 2 1/2 times its projected five-year annualized earnings growth rate of 16%.

The high valuation no doubt stems in part from investors' worries about the market and their attraction to large, supposedly safe, stocks. But it's more complex than that.

Rudnick compares Coke to the former CPC International--which is now Bestfoods (BFO) after the January spinoff of its corn refining operations--because Coke and CPC are in the same food and beverage industry. CPC traded at a far lower multiple than Coke despite a projected five-year profit growth rate of 14%, he said.

But at year-end, Coke's 56% return on equity, a key measure of financial performance, was more than double CPC's 27%, Rudnick said. Coke's operating profit margin was 22.6% to CPC's 12.3%.

So part of the reason investors are willing to pay up for Coke's steady earnings is because its underlying fundamentals show Coke's earnings are extremely likely to remain consistent.

"If you just looked at the expected growth rates, you would say, 'There's only a 2% differential--the dramatic diversity in their P/Es doesn't make sense,' " Rudnick said.

Investors also should understand the principle of P/E expansion. This happens when the P/E of a stock or the broad market swells to, say, 25 from 15. The multiple isn't necessarily too high. Rather, the acceptable P/E may have simply expanded, usually because inflation and interest rates are low--exactly what has happened over the last five years.

When rates and inflation are tepid, investors will pay more for stocks relative to their earnings. The economy is chugging along. Low rates help profitability. And with competing investments such as bonds paying meager returns, there's even more reason to buy stocks.

P/E expansion is a powerful force. From the onset of the bull market in mid-1982 through the end of 1997, the Standard & Poor's 500 soared 770% in price, Toledo said.

S&P 500 earnings, by contrast, only tripled in that period. That means a big part of the S&P's price gain is explained by an almost threefold expansion in the P/E ratio, to 23 currently from 8 in 1982.

Is 23 times earnings too high? Was 17 too high four year ago? If the economy, and earnings, go the wrong way, 23 might well be excessive. But if inflation, interest rates and profit growth stay favorable, Wall Street may not know what "too high" is.

*

Street Strategies explores investment tactics. Times staff writer Walter Hamilton may use strategies he writes about in his personal account. He can be reached at walter.hamilton@latimes.

(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)

Ratios by Market Sector

One way to judge an individual stock's price-to-earnings ratio is to compare it with the average P/E of its industry. Average trailing P/Es each year since 1994 for major market sectors, plus the four-year average for each:
                        1994  1995  1996  1997  4-yr. avg.
Capital goods           28.7  32.2  34.7  25.2        30.2
Technology              37.2  16.0  22.4  28.2        26.0
Consumer staples        18.7  20.8  24.7  29.0        23.3
Health care             17.4  19.7  24.0  30.6        22.9
Retailers               19.7  18.1  21.9  26.0        21.4
Communication services  19.9  19.0  20.9  22.7        20.6
Basic materials         24.5  14.1  17.4  25.4        20.4
Energy                  20.4  18.4  18.0  17.9        18.7
Chemicals               23.9  14.0  15.5  19.2        18.2
Consumer cyclicals      15.6  14.4  18.0  17.5        16.4
Utilities               16.2  14.6  14.3  15.3        15.1
Insurance               15.8  13.9  13.0  15.8        14.6
Financial               10.1  11.6  13.1  16.7        12.9
Banks                    8.5  10.4  13.2  18.1        12.6
S&P 500 index           17.3  16.5  19.1  22.0        18.7

Source: Standard & Poor's

GRAPHIC: GRAPHIC-TABLE: Ratios by Market Sector, Los Angeles Times

LANGUAGE: English

LOAD-DATE: February 28, 1998

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