Investing–The New Rules: Determining Stock Value Using P/E10

Use P/E10 to help size up income streams of stocks before buying

Looking at income streams is one way to determine the value of stocks before buying. P/E10 is our starting point. Rob Bennett explains in this week’s Investing–The New Rules.

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Investing — The New Rules
Choosy Mothers Choose — Low-Priced Stocks?

#11–July 12, 2010

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I’ve explained in earlier columns that stocks are like anything else you buy in this Consumer Wonderland of ours. They represent a wonderful value proposition when you pay a reasonable price. Overpay, and stocks become a rip-off. P/E10 is the thing that tells you whether you are overpaying or not. P/E10 is the price tag for stocks.

You need to know how this works.

Say that you were buying a jar of peanut butter. How would you go about determining which jar of the many offered for sale at the grocery store represents the best value proposition?

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You cannot go by price alone. A jar of peanut butter that sells for $2 is not a better deal than a jar that sells for $4 if the more expensive jar contains three times as many ounces of peanut butter. The way to figure out which jar offers the best value proposition is to compare how much you are paying per ounce of peanut butter. The more ounces of the stuff you want (peanut butter) you get for each dollar you give up, the better you are doing.

It works the same way with stocks.

You are not buying stocks to get nutrition and that smooth buttery taste, of course. What you are buying is an income stream. There are two things that you need to know to know whether stocks are worth the price being charged or not: (1) the size of the income stream you are buying; and (2) the number of dollars you are being asked to give up to obtain each dollar of that income stream.

The income stream you are buying when you buy U.S. stocks is a return of 6.5 percent real per year. That’s been so for as far back as we have records. So that one’s easy.

The one that causes some “controversy” is the second one, the number of dollars you are being asked to give up to obtain each dollar in that income stream. The Stock-Selling Industry doesn’t want you to look at that number. I’m not in The Stock-Selling Industry. I do.

The “E10” in “P/E10” is the average of the last 10 years of earnings of the companies in the broad stock index you are thinking of buying (for example, the S&P 500). The “P” is the price of the stock index. When the market has a P/E10 of 14, you are paying $14 for each dollar of annual earnings that will be coming to you as the result of your purchase of a broad index fund.

Is that good?

When you pay $14 for each dollar of annual earnings, it will take 14 years for you to break even on the investment. Once you reach the break-even point, every dollar of earnings generated from that point forward is pure profit. From the break-even point forward, your gains just grow bigger and bigger and bigger. An index fund with a P/E10 of 14 represents a very good deal indeed. Buying into value propositions like that will in time make you rich.

What if the P/E10 is 8, as it was in 1982? That’s even better. When the P/E10 is 8, you break even in 8 years. Then its all downhill sledding. How can you lose?

What if the P/E10 is 44, as it was in January 2000?

Not so good.

You’ll break even eventually even when you buy stocks at a P/E10 of 44. But you better eat right and avoid having fun in general or you may die before doing so. It takes a long, long time to break even on a purchase of stocks bought at the sorts of prices that have applied since the mid-1990s. You’re paying too many dollars for too few ounces of peanut butter at those prices. During the decades in which you are waiting to get to the break-even point, others will be buying stocks at far better prices and reaching their break-even point much sooner.

It makes perfect sense. It’s easy to understand. Everyone should invest this way. Everyone would except for one thing. There is an awful lot of money to be made though the promotion of Buy-and-Hold, the alternative approach (Buy-and-Holders pay no attention to the price of the stocks they buy and thus often direct their money toward horrible value propositions, setting back their retirement dreams by years or even decades). Buy-and-Hold benefits The Stock-Selling Industry. P/E10 benefits the investor — You!

Say that you wanted to promote Buy-and-Hold and that you noticed that P/E10 provides an easy way for all investors to see through the marketing trickery. What would you do?

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ALSO at DBKP:
* Investing–The New Rules: The Monster That Ate the U.S. Economy
* Investing–The New Rules: Stocks Are Not Worth Buying Today
* Investing–The New Rules: Sarah Palin Will End Economic Crisis
* Investing–The New Rules: Dollar-Cost Averaging is a Loser
* Investing–The New Rules: John Bogle’s Evil Twin?
* Investing–The New Rules: Stock Return Predictor Not a Case of ‘Too Good to be True’
* Investing–The New Rules: The Stock Investor’s Weather Report
* Investing–The New Rules: Harness the Power of The Stock Return Predictor
* Investing–The New Rules: Get the Odds on Your Side
* Stock Investing: Much of Today’s Understanding is Primitive

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If you were smart (not also good or kind, but just smart), you would try to confuse matters by promoting valuation metrics that do not work as well as P/E10. You will often hear the experts advocate use of P/E1, the price of the index over the earnings for the last year (rather than the average of the past 10 years). P/E1 sometimes works. But it is unreliable. At times when the economy is gong gangbusters, the earnings for only a single year are not representative of what you can realistically expect on a going forward basis. It’s the same when the economy is in a big slump.

So P/E1 does not work too well in predicting long-term returns. When the experts push it, investors come to the conclusion that it is not possible to predict returns effectively. And they conclude that they might as well just go along with the marketing slogans and follow a Buy-and-Hold strategy. How convenient for the “experts”!

Don’t be intimidated when you see the term “P/E10.” P/E10 is our tool for avoiding the trickery of the stock selling experts. You wouldn’t dream of buying a car without first looking at the price. Or a book. Or a phone. Or a sweater. You’ll spend more on stocks in your lifetime than you will on cars or books or phones or sweaters. You need to make it a practice always to look at the price at which stocks are selling before putting money down on them too.

by Rob Bennett
images: DBKP file; freelance switch

Rob recently authored a Google Knol entitled “The First Retirement Calculator to Get the Numbers Right.” His bio is here. And please do not even think of failing to read these Important Cautionary Words.

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