Low inflation debunks PE-based scare theory

PUBLISHED : Tuesday, 21 July, 1998, 12:00am
UPDATED : Tuesday, 21 July, 1998, 12:00am

There is a school of investment thought which holds that you buy a stock when its earnings growth is higher than its price-earnings ratio and sell it when its earnings growth is lower.

If the growth of earnings per share, for instance, is 20 per cent and the share price is 10 times those earnings then the stock is a screaming buy. If the reverse, then sell the stock.

It's an appealing idea in its simplicity. It also does not work very well.

Almost every study done on it shows that there is only a very loose correlation between earnings growth and PE ratios, if there is any at all.

But enough people subscribe to it to make the US stock market appear vulnerable at the moment. Earnings growth in the US is sliding and is at best only in low single digits. Meanwhile, the PE ratio of the US market is in the mid-20s.

Surely there is a bubble here that must burst soon, the pessimists argue.

Good times cannot last forever in the US, and already there are warning signs in several areas of the US economy.

What is more, if Asian markets are in the dumps now, what will happen to them if the US market crumbles? They may have gone in different directions over the past year, but, historically, Asia has been helped by good times in the US; if the US should turn sour, Asia could turn even more poisonous than it already is.

The weakness in the pessimistic argument lies squarely in that concentration on growth. It is true that earnings growth can make a share price go up, but look instead at the difference between the price and the price-earnings ratio.

Take a stock priced at $1, with earnings per share of 10 cents. It is priced at 10 times earnings. Now push the earnings up to 15 cents and it is very likely that the share price will go to $1.50. This still, however, leaves it at 10 times earnings.

The share price may be driven by earnings growth, but the basic price-earnings ratio is determined by what else you can do in the same currency. Investors look at a wide array of different things they can do with their money, and if property, for instance, returns twice as much money as stocks, then sooner or later property prices will go up and share prices will go down until the risks and rewards between them are brought back into balance.

The greatest single determinant of what this general level of pricing in financial assets should be is inflation. With high inflation, you want low prices to compensate you for what inflation takes away. With low inflation, you'll accept higher prices.

So look at the US inflation rate. It is at near record low levels, has been there for a long time, shows few signs of rising and US interest rates have followed it down. There is not much reason to worry about the PE ratio of the US market while this continues.

US PE ratios are high because inflation is down and this has little to do with earnings growth. Asia faces no big danger here.


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