Are Stock Prices Too Stiff?

Smithfield Foods makes ham, bacon, sausage--and so much money that shareholders have been squealing with delight. As profits rose sharply in 1991, Smithfield's share prices doubled. But investors who bought into this Virginia-based company in recent weeks, expecting that earnings would rise 10% over the year before as predicted by analysts, found themselves saddled with a pig in a poke. On Feb. 18, Smithfield stock slid 7% on the news that quarterly profits had fallen by nearly 30%.

The earnings shortfall at Smithfield Foods Inc. typifies the dilemma facing stock market investors. Lofty earnings expectations have been driving the market ever higher for much of the past year. But if profits falter, as they did at Smithfield, share prices could take it on the chin. Nowadays, brokerage-house analysts are predicting that earnings of companies in the Standard & Poor's 500-stock index will advance 39% in the coming year. That would be a stunning reversal from 1991, when the S&P 500 companies saw their profits decline by 10.5%. The market, however, has taken this anticipated profit gain into account--by pushing price-earnings multiples to levels that are rarely seen. The Dow Jones industrial average is 52 times estimated 1991 earnings, three times the level of a year ago, while the S&P 500-stock index is 22 times expected 1991 earnings. And even using the 1992 earnings estimate, the p-e is still historically high: 15.6 (chart).

Is the market too expensive? With stocks treading water for most of the past few weeks, investors apparently are saying "Yes." But the market's p-e ratios may not be quite as terrible as they seem. The market valuations may well be justified by the same ultralow interest rates that have so antagonized savers. "You have to look at the p-e multiples from a monetary perspective," asserts Oppenheimer & Co. analyst Paul S. Rabbitt. One method used by Rabbitt is to look at the historic ratio of the earnings of S&P 400 industrial stocks, as compared with the yield of three-month Treasury bills. This analysis tells Rabbitt that the price-earnings ratio on the S&P 400 could rise from a current 25 to as high as 30 before it would become overvalued.

ROOM TO GROW. Rabbitt has a point. So long as rates remain low, and profits don't tank, the market should continue in high gear. "In terms of historical valuation experience, it might appear that stocks are overvalued," says Suresh Bhirud, who runs the Bhirud Associates research boutique. "But with rates below 4%, one can begin to make the argument that there is room for price-earnings multiples to expand." Bhirud notes that another valuation measurement, in which the dividend yield of the S&P 400 is divided into the yield of the three-month Treasury bill, indicates to him that p-e multiples have room to increase by another 20%.

Still, some market observers argue that the market's price-earnings ratios are moving to dangerous territory. They maintain that corporate profits will remain under pressure in the year ahead unless the economy revives more swiftly than expected. They point out that negative earnings surprises continue to pummel stocks and that estimate downgrades have outpaced upgrades by a 4 to 1 margin--a sign of earnings weakness. "I would have to say, from a valuation perspective, that stocks are looking pricey," reports Melissa R. Brown, who is chief quantitative analyst at Prudential Securities Inc.

One way of assessing the market's valuation is to calculate p-e multiples using projected 1992 earnings instead of 1991 profits. Proponents of this technique point out that investors tend to judge stocks on the basis of their expected earnings for the coming year and not the year just passed. This figure is sometimes calculated by using estimates of overall corporate profits by economists and market strategists--the "top-down" approach. But this year, because of a spate of corporate restructurings that have skewed such calculations, it seems better to use earnings estimates for each of the 500 individual stocks in the index. Using this "bottoms-up" approach, the p-e of the S&P 500 is 15.6, according to Zacks Investment Research, a Chicago firm.

ALL RELATIVE. A market p-e of 15 or higher is not unusual using the previous year's earnings, but is uncommon when looking ahead to the coming year. "I can't recall the number ever being that high," says Benjamin Zacks, an executive vice-president of the firm. A year ago, just before the market advance, the market was trading at 12 times projected 1991 earnings. That was typical. Over time, according to Zacks, stocks have tended to be priced at about 11 to 13 times their projected earnings in the year ahead (chart). Even at this time in 1987, he notes, the market was trading at just under 15 times projected 1987 earnings. "If a p-e of 12 1/2 is fair value, then the market is 24% overvalued," Zacks maintains.

Judged in isolation, this p-e spells trouble. But p-e ratios should not be judged in isolation. When compared with short-term interest rates, the number appears far less threatening. True, the market's p-e was 12 a year ago, but short-term rates were 6.2%--more than 50% higher than they are now. Adjusted for the difference in rates, that would make the market's p-e a year ago the equivalent of about 18.

At bottom, then, the argument about earnings and p-e ratios is all relative. "The biggest bear market in recent years took place in 1973 and 1974," Bhirud recalls, "and that was when earnings exploded." Back then, of course, rates were exploding, too. Today, the byword is deflation. So long as interest rates stay low, they will continue to take the sting out of those nasty-looking p-e numbers.

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