ANALYSIS FOR WAL-MART
Conversely, companies' P/E multiples soared to 40 or more times earnings in 1968 and 1972, when interest rates were much lower. Interest rates at this time were 5 to 6 percent, but future growth expectations were very high.
There is also a strong inverse correlation between the long-term inflation trend and the P/E multiple. During inflationary periods, P/E ratios have ranged between 5 and 10. The ratio rises to between 15 and 20 in disinflationary or deflationary times.
A rule sometimes cited is that stock market conditions determine 50 percent to 55 percent of a stock's performance, the industry group determines 30 percent, and the company itself represents 15 to 20 percent. The 50 to 55 percent attributed to stock market conditions may be justified by the fact that the P/E reflects the market, which in turn reflects interest rates. Conversely, interest rates reflect the market, which is reflected by the P/E multiple. However, a flaw in the industry group theory, which determines 30 percent, is it incorrectly assumes a stock has no unique characteristics. An example is SmithKline Beecham and its Tagamet product for treating ulcers, which afforded it a multiple well above the average for the pharmaceutical group at the time the drug was introduced.
Data going back to the 1930s shows conclusively that stocks with low P/Es outperform stocks with high P/Es over the long term in virtually every period analyzed. More recent studies show similar results. Over the long term, a low P/E strategy enables investors to outperform the market and is valid regardless of the market performance at any particular time.
There are two reasons why this strategy works. First, a high P/E by definition has high expectations for earnings growth. Indeed, it discounts all good news and opens the door for a rapid adjustment in the price (and hence the multiple) to lower expectations when disappointing earnings are reported. Second, a low P/E stock may be relatively unknown and not yet have a strong analyst following. Chances are higher that a neglected stock is undervalued than that a popular issue is.
Low P/E multiples become high P/E multiples when expectations change. A good example is the telephone industry's traditionally low multiple, which changed as new technology (such as cellular telephones and fax machines) increased demand and deregulation enhanced earnings. Unless expectations change, however, a low P/E stock could retain its deserved low multiple.
Model #2: Return on net assets The second major method of equity evaluation is return on net assets, including asset valuation. Asset valuation assumes the market price of a stock selling below its book value will rise toward this value if the book value reflects the true current value of the assets, whether appreciated or depreciated.
If the net assets (total assets minus total liabilities) per share are below the current market price, the assumption is that current management is failing to generate adequate returns from the company's assets. There are two approaches to this analysis.
First, by taking current net income [next page]