Friday, May 19, 2017

Explaining Price/Earnings in Plain English to Judge Current Valuations

We have all heard the adage to buy low and sell high. That sounds great, but what exactly does that mean within the world of stock and bond investing? One of the most fundamental measurements in making this assessment is the price to earnings ratio (P/E). Essentially when you are buying a stock or a bond, you are buying a future income stream generated by earnings. If you pay a high price for those earnings, you are limiting the likely possibility for appreciation. The reverse, of course, is similarly the case.

Allow me to expound upon this concept in plain English. Let’s say we own a lemonade business that earned $10,000 and has issued 10,000 shares of outstanding stock. In that case we would have earned $1 per share. Now, let’s say our company earns $1 per share, but is trading at a price of $15 per share, then our price relative to earnings or P/E ratio is 15. If earnings remain flat but the price of our stock goes to 25, then our P/E ratio would escalate to 25.

The S&P500 is a composite of 500 stocks listed in the U.S. from vast and diverse sectors of the economy. The historical median score for the P/E of the S&P 500 is around 15. When the P/E falls within single digits, the market is considered cheap and undervalued. Buying into the S&P 500 when its P/E is within the single digit range is the classic definition of “buying low”. Buying into the S&P 500 when its P/E is around 15 means that based on this measure, one should anticipate an average prospective return.

 Today, the P/E for the S&P 500 is a bit over 25. Going back to our lemonade example, if our lemonade company were trading at the current level of the S&P 500, it would mean that investors would be buying into a company trading at 25x its current earnings. Evaluating long-term P/E ratios of the S&P 500  averaged over a ten year rolling term, and comparing where the number is today indicates that we sit today at the second highest level ever, and only exceeded in the year 2000 at the peak of the dot com era.

So far in 2017, nearly half of the gains in the S&P 500 index have come from just 10 companies. And, to even further elucidate how narrow the range has been, the vast majority of these gains have come from just five companies. To provide a greater sense of the degree to which the major indexes such as the S&P 500 and Nasdaq have been pushed higher by a slim margin of companies with extended P/E ratios, I would like to provide some examples. The trailing twelve month P/E ratios for Amazon, Netflix, Facebook, Microsoft, and Google are 178.5, 205, 38.21, 30.2, and 32.30 respectively. That means investors in Amazon are paying 178.5x earnings generated over the last twelve months. Netflix investors are paying 205x earnings, and investors in Facebook are paying 38.21x earnings.

Passive index funds have experienced the greatest inflows of capital over the last nine years. In fact, over this time frame, inflows into such funds have grown at an annual rate of somewhere estimated around 20%-25%. Indexes, and therefore the index funds which are designed to mimic the index, are disproportionately weighted to companies with the largest market capitalizations, and therefore commonly those with the most elevated P/E ratios. For example, within the S&P 500, Apple constitutes about 3.5% of the index. Facebook comprises 1.6% of the index. Amazon counts for 1.7%, and Microsoft and Google each comprise roughly 2.5%. With respect to the Nasdaq, Apple, Amazon, Google, Microsoft, and Facebook comprise 12%,7%,9%,8%, and 5.5% respectively. So, as all of this money has flowed into passive index funds post the financial crisis, most of it has concentrated amongst a relatively minute number of companies.

By investing into index funds, investors have ignored market valuations and concentrations. It is tantamount to investors buying shares in my lemonade business at wildly high multiples and expecting that my earnings will somehow skyrocket and/or that the price other buyers will pay for my lemonade will continue to increase pushing multiples to even greater extremes. If we are to buy low and sell high, now is a critical time to evaluate your holdings.






The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.  All performance referenced is historical and is no guarantee of future results. There is no assurance any of the trends mentioned will continue in the future.

All indices are unmanaged and cannot be invested into directly. Unmanaged index returns do not reflect fees, expenses, or sales charges. Index performance is not indicative of the performance of any investment.

How a Pension Valuation Can Be Used to Negotiate a Marital Settlement Agreement

 Marital Assets

Home worth $500,000. No mortgage. Husband’s 401k worth $750,000. Wife’s 403b worth $150,000. Non-retirement investments also worth $120,000. Husband and Wife each have defined benefit pension plans.

Husband earns $110,000. Wife earns $80,000

Wife’s Proposal

Divorce is initiated by Wife. She seeks no alimony. She establishes that she must retain ownership of the home ($500,000 asset) and that she will offset this $500,000 amount from Husband’s 401k of $750,000 leaving $250,000 that she says should be split in half thereby asserting her claim to $125,000 of his 401k. She also says her 403b amount of $150,000 should be split in half or $75,000 to each, and proposes to subtract this $75,000 from the $125,000 that she is “owed” from his 401k. She also says that she will retain her pension and Husband will retain his pension.
Reality Derived from Valuations

The cost basis in the home is $260,000. Therefore, if Wife retains ownership exclusively, her net equity will be below the $250,000 taxable exclusion, making the house a tax-free asset for her. In contrast, his 401k and her 403b are subject to full income tax rates. Conservatively, we attributed a 25% tax rate to each, resulting in a net value of $563,000 and $113,000 for his 401k and her 403b respectively. Analyzing the tax ramifications for the different assets punctured a hole in Wife’s proposal. With the tax analysis overlay, the home equity and the value of Husband’s 401k were almost the same. She quickly backed down from asserting rights to his 401k.

The other part of the analysis that punctured Wife’s proposal emerged from getting more data on each pension plan. From each spouse’s plan administrator, we learned that in 8 years, she is eligible for full retirement pension benefits of $3340/month, and that he was eligible for $2200/month in that same year. Not only are the monthly distribution amounts not equivalent, but additionally the life expectancy and mortality rates are very different based on their ages and gender. In fact, the net present value of her pension came to almost $800,000 where his came to about $400,000.


Although the parties were initially diametrically opposed, and Husband felt that Wife’s proposal would have taken him to the cleaners, as a result of the financial analysis, Husband will not have to share any of his 401k, and other than a small stipend as an emergency cash cushion for Wife, Husband will receive all non-retirement investments. Each will retain his and her pension, and Wife will retain the house. Agreement was reached because now Husband has adequate cash to make a down payment on a home for himself. Under Wife’s proposal, he would have had to not only turn over some of his 401k to her, but he would have also had to have borrowed from the 401k in order to make a down payment.
Moral of the Story

Although Wife’s proposal on its face seemed very logical and reasonable, exposing the implications of both the latent tax and pension valuations that were unknown to the parties facilitated compromise and negotiation and a shift in the power play where each side got enough of what was important to him and her to settle. Imagine how Husband or Husband’s counsel would have felt had they failed to identify the rationale for such valuations and their ultimate impact on the terms of the marital settlement agreement. 


This is a hypothetical example and is not representative of any specific situation. Your results will vary.