Art and Sciences
A final word on P/Es

by Ann Coleman (TMF

Alexandria, VA (March 1, 1999) -- Stock pricing is at least as much art as science. The great stock pickers have always had a feel for what will fly and what won't. Peter Lynch bought Taco Bell because he liked their burritos. (He's from Boston, and they just didn't know any better up there in the '70s.)

At the risk of sounding just a bit repetitive, I have to say that one of the beauties of the Foolish Four approach is that it requires no art and almost no science. For those of us whose clay Easter bunnies always bore an amazing resemblance to our clay Easter chicks and the Thanksgiving turkeys, that's a comforting thought. And for those of us who knew what real burritos tasted like and were sure Taco Bell was just another flash-in-the-pan, it's a really comforting thought. (For the record, I've grown to like Taco Bell burritos, as long as I haven't eaten anything to compare them with recently. Obviously, though, Peter Lynch's tastes were much more in sync with the rest of the country.)

On the science side, things are easier. All you have to worry about are numbers. We've been investigating the premier investing number, the Price to Earnings Ratio, lately. Dividing the price by the earnings per share is a whole lot easier than guessing whether the public will prefer cassettes to 8-track tapes or Betamax to VHS.

We have talked about what goes into the P/E in previous columns, but there is one more aspect of the price to earnings ratio that I want to cover before moving to another topic. It's the way the P/E works for the market as a whole. That is, if you compare the earnings for some group of stocks with the price of all the companies in that group, you can get the P/E of the whole market, or an index, or just an industry. Comparing the P/E of a particular stock with the P/E of its industry is one very good way to see how your stock is valued relative to other companies, which should be facing many of the same conditions.

The Market P/E is a very hot topic right now, since the P/Es for the Dow Jones Industrial Average and Standard & Poor's 500 Index are higher than almost anytime in the past. This has prompted those many warnings you may have seen about the market being poised for a fall or being terribly overvalued. The concern is that, on average, investors are paying more for each dollar of earnings than they have ever been willing to pay in the past.

Some of what we are seeing, though, is the average being pulled way up by technology stocks, which are selling at very high P/Es basically because the "market" values their potential earnings very highly. Imagine yourself at the turn of the last century. If you knew then what you know now, do you think you could manage to become rich in the stock market?

I mean, if this were 1899, what would you be investing in? Railroads and oil? Electric utilities? That newfangled telephone thing? Were there any public automobile companies at that point?

Today, there is a pretty strong consensus that the growth stocks are technology, communications and biotechnology. These days we have the advantage of seeing what opportunities there were 100 years ago. That's what's driving the high P/Es of these stocks. No one wants to miss out on the next AT&T (NYSE: T) or the next Exxon (NYSE: XON).

Of course, many of those oil, railroad, and phone stocks went ka-blooey, and many of today's tech stocks will do the same, but the winners will win big -- and that's what everyone is betting on.

Does that mean that the market as a whole is overvalued? Or does it portend a collapse of the entire market if the technology bubble should burst? (You don't expect a straight answer to that, do you?) Well, many traditional industries are also selling at high P/Es relative to their historical levels. Maybe that means that the market is due for a major correction, or maybe it reflects the fact that the baby boomers are throwing so much money into the market that the perception of how valuable those earnings are has changed and will remain changed as long as the boomers keep investing. Or maybe it means something else entirely that will undoubtedly become clear in hindsight.

Once again, we come down to the impossibility of predicting the moves of the market as a whole. What is not impossible is finding companies that have demonstrated a long history of making money and buying them when they are relatively cheap. (That's what the Foolish Four does, using a shorthand formula to decide which stocks are right to buy at any given time.) It's not the only way to invest, but it is one of the safest and surest. Especially for taco snobs.

Fool on and prosper!

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Today's Stock Lists | 1998 Dow Returns

03/01/99 Close
Stock  Change   Last
CAT  +3  5/8   49.19
JPM  +   3/16  111.63
MMM  -   1/2   73.56
IP   -1  1/16  40.94
                   Day   Month    Year   History
        FOOL-4   +1.42%   1.42%   2.45%   3.97%
        DJIA     +0.20%   0.20%   1.71%   1.31%
        S&P 500  -0.18%  -0.18%   0.88%   1.13%
        NASDAQ   +0.31%   0.31%   4.67%   6.11%

    Rec'd   #  Security     In At       Now    Change

 12/24/98   24 Caterpillar   43.08     49.19    14.18%
 12/24/98    9 JP Morgan    105.51    111.63     5.80%
 12/24/98   14 3M            73.57     73.56    -0.01%
 12/24/98   22 Int'l Paper   43.55     40.94    -6.00%

    Rec'd   #  Security     In At     Value    Change

 12/24/98   24 Caterpillar 1034.00   1180.50   $146.50
 12/24/98    9 JP Morgan    949.62   1004.63    $55.01
 12/24/98   14 3M          1030.00   1029.88    -$0.13
 12/24/98   22 Int'l Paper  958.12    900.63   -$57.50

              Dividends Received      $15.04
                             Cash     $28.26
                            TOTAL   $4158.93