Forward Price To Earnings Ratio (Forward P/E), Shiller P/E
Buying ceaselessly rising stocks prices was hardly logical. The higher the P/E ratio, the more the market was willing to pay for each dollar of companies’ annual earnings. After all, buying increasingly over-valued stocks investors showed disrespect to economic standards. Analysts, working from the brokerage industry, had hard nut to crack how to explain it. Making an effort to meet the wishes of the general public, they devised new methods, enabling investors to evaluate companies higher. Arguing that the existing P/E ratio does not take into account companies’ prospects, they acknowledged that price-to-earnings ratio could be modified. Instead of use to calculation current earnings they suggested forecasted ones. It should be noted that there never was mathematical basis for what a company's P/E should be.
An exemplary definition of the new indicator, that was called Forward Price To Earnings ratio or Forward P/E (also "estimated price to earnings") is presented below:
The price of a security per share at a given time divided by its projected earnings per share over the coming year. A forward P/E ratio is a way to help determine a security's stock valuation (that is, the fair value of a stock in a perfect market). It is also a measure of expected, but not realized, growth.[1]
The earnings used in the formula are for the next 12 months. The indicator was not reliable as previous, but justified higher valuation of stocks. The new indicator had one more good point - allowed making numerous liberal exemptions in calculating the forward P/E, e.g. 'one time' companies expenses (as such, they could be not taken into account). As an effect, its value started to increase.
Michael Fan of Stanford University wrote about the problem with calculating P/E as follows:
Although P/E is a very good metric to use, there are various ways that it can be manipulated to represent something that the companies want you to see. P/E is based upon the earnings of the company, and the accounting process could come up with numbers that don't accurately reflect the true state of the company.[2]
In 1981 professor of Economics at Yale University Robert J. Shiller published an article in the American Economic Review titled: Do stock prices move too much to be justified by subsequent changes in dividends? He criticized the efficient markets model, arguing that: “In a rational stock market, investors would base stock prices on the expected receipt of future dividends, discounted to a present value”.[3] He created the new indicator called P/E10 or Shiller P/E. It is the price to average earnings from the past ten years based on average inflation-adjusted earnings from the previous 10 years.[4] Thanks to earnings from the previous ten years, it is less prone to swings that could take place in any one year.
Exemplary P/E ratio in numbers and what they say about stocks:
N/A A company with no earnings has an undefined P/E ratio. By convention, companies with losses (negative earnings) are usually treated as having an undefined P/E ratio, even though a negative P/E ratio can be mathematically determined.
0–10 Either the stock is undervalued or the company's earnings are thought to be in decline. Alternatively, current earnings may be substantially above historic trends or the company may have profited from selling assets.
10–17 For many companies a P/E ratio in this range may be considered fair value.
17–25 Either the stock is overvalued or the company's earnings have increased since the last earnings figure was published. The stock may also be a growth stock with earnings expected to increase substantially in future.
25+ A company whose shares have a very high P/E may have high expected future growth in earnings or the stock may be the subject of a speculative bubble. [5]
S&P 500 P/E Ratio based on average inflation-adjusted earnings from the last 100 years (Shiller P/E Ratio, or P/E 10) [6]
The exceptional role of the USA economy in the “global economy”. The hazardous feedback between the stock market and economy in general.
1. Who governs Wall Street – bulls or bears? The role the mass media in the stock market
Stock investing in assumption is an optimistic activity since it bets rising stock prices. Most people (and Americans in particular) have a natural tendency to be optimistic. Stock market bears for ever have been struggling with a perpetually bullish "Wall Street Industrial Complex" – the institutions designed to sell securities to the public. They promote stocks as safe place to invest capital. Since the main activity of bears consist in “short selling” – selling borrowed from a broker stock with the obligation of purchasing it back later with the profit being the difference between the sale price and the repurchase price, presumably lower – bears are natural enemies of those institutions. Trading commissions of short sellers generate little revenue for the brokerage industry that needs a constant inflow of new capital to survive and actually earns huge money from management fees, investment banking, research, and related activities. Their continuously bullish marketing luring investors to buy products and services they offer is propped up by the financial media who receive the money from them for advertisements. At present there are two 24-hour "news" channels, CNBC and Bloomberg, that are engaged in the stock market business. Their influence is powerful and pervasive. Most common investors believe in their point of view - continuously bullish - and buy shares. It is not without reason that during the last 20 years the saying “you snooze, you lose” made a great career, persuading in media investors not to lose an opportunity and buy shares. They are always “cheap”, “promising” or at least “fairly valued” and never too expensive.
In turn, even though there is nothing illegal or unethical about short selling, the people engaged in this pursuit are not the most popular on Wall Street. The word “bear” on the stock market means pessimistic, freaky and ridiculous as such people do not believe in the country’s prospects. During bear markets, when the majority of investors loses large sums of money, bears create resentment and are even accused of “rogue practices”. Moreover, many consider unpatriotic to sell short the country's finest companies and profit from their troubles. Some critics believe that short sales are a major cause of market downturns. For example, two years after the crash 1987, the U.S. government lawmakers considered regulation after allegations of widespread manipulation by short sellers. Although SEC officials reassured the public that manipulations hadn't been uncovered, more rules for short selling was introduced.[7]
There is not only the brokerage industry that presents the bullish point of view. As the influence of stock markets on economic growth is undeniable, the same attitude must be supported by the government. It leads to the situation that every rise on the stock market is seen as a joined success of the government and the citizens of the USA, confirming that the country heads in the right direction, and simultaneously any larger fall is perceived as suspicious, unjustified and posing threat to life of Americans. The symptomatic behavior took place after 9/11 terrorist attack, when media urged people not only not to sell shares, but on the contrary, buy them – considering this as a highly patriotic act:
Media Peaceful Ways of Fighting Back Against Terrorism. Keep your money in the stock market; leave your investments where they are. Show your faith in our economy by investing in the stock market. [8]
The other problem touches personal pension plans. Since the early 1980s there has been an explosion in individual accounts, that would be used for the generation of retirement income. In the USA there are two types plans: fixed income, that invest in bonds, ensuring to stable portfolio, and equities, that offer potentially more money but simultaneously adding volatility. Some criticize the second, arguing that because of the volatility of equity market, the personal pension plans would not be unable to provide a satisfactory pension to all retiring workers.
To sum up, apart from few bears there are no people in the USA, who would be interested in falling share prices. Unfortunately, rising feverishly prices must fall, making a large sum of money to evaporate and posing risk to the country and its citizens. Theoretically, the government and its agendas should leave the stock market alone. Ultimately, there are forces of demand and supply that have been making him functioning properly since ages and every artificial way of influencing them proved to be wrong. But is it for real?
[1] http://financial-dictionary.thefreedictionary.com/Forward+Price-to-Earnings+Ratio
[2] http://www.stanford.edu/~mikefan/metrics/peratio.html
[3] http://www.nber.org/papers/w0456.pdf
[4] http://www.multpl.com/
[5] http://globotrends.pbworks.com/w/page/14808661/P-E%20ratio
[6] ibidem
[7] http://www.sec.gov/rules/concept/34-42037.htm
[8] http://www.journeyofhearts.org/kirstimd/911_cope.htm
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