Numbers Can Be Deceiving

by | Jul 14, 2003

Let’s dig deeper into the bull-versus-bear debate that has dominated my last few columns. I’ve taken the bullish position — but I’m not rabid about it, and I’ve discussed the things that worry me, too. I’ve gotten tons of email from readers along the way — mostly from angry bears, and some from gun-shy bulls […]

Let’s dig deeper into the bull-versus-bear debate that has dominated my last few columns. I’ve taken the bullish position — but I’m not rabid about it, and I’ve discussed the things that worry me, too. I’ve gotten tons of email from readers along the way — mostly from angry bears, and some from gun-shy bulls — but there’s one element on which they all seem to agree: None can figure out why I keep saying stocks are undervalued.

There seems to be a universal consensus among readers that stocks are, in fact, quite overvalued by historical standards. So they assume I’m cheating when I say “the market is undervalued” or “stocks are cheap.” They think it’s just a tricky way of saying that I think the market will be higher in the future, without any real reference to objective standards of valuation. So let me set the record straight — I have very good objective grounds for saying that stocks are undervalued.

If nobody believes me, that’s fine. I guess that’s why stocks are so cheap to begin with — because everyone thinks they’re expensive. That sounds like opportunity knocking, to me. But I hate to have my readers make a big mistake here, so let me explain my thinking on valuation.

First, let’s agree on terms. When I say “valuation” I’m using the word in a fairly conventional sense — I’m talking about how much investors are willing to pay for earnings. Of course, the most common way of thinking about that is the market’s price/earnings ratio. Most readers seem to think that the P/E ratio for the Standard & Poor’s 500 is somewhere between 30 and 40 — in other words, you have to pay between $30 and $40 per share for each $1 in annual earnings.

So right off the bat, that prompts the question “what do you mean by earnings”? In today’s world of complex (and sometimes overly creative) accounting, that’s a tricky question. But the right answer isn’t to be perversely “conservative” about it by including every ambiguous negative and excluding every ambiguous positive.

When you do that, you’re including negatives like massive noncash write-offs which have no rational connection to anything you’d want to think of as “earnings” — for example, AOL Time Warner’s $54 billion write-off last year, which, all by itself, would reduce S&P 500 earnings by more than 10%.

And now the overly conservative fashion is to include options-based compensation, and exclude positives like pension fund gains. OK, there are good rationales for both of those — but unless you go back in history and treat past earnings the same way, you’ll end up making today’s earnings look artificially bad. And isn’t the whole point of valuation analysis to compare today’s values in a consistent way to the values of the past?

If you throw out all of that and look at earnings on a historically consistent basis, today’s S&P 500 price/earnings ratio is actually about 20. That compares to an average over the last 50 years of about 15 — so even using my definition of earnings, how can I say that stocks are undervalued?

First, you have to take taxes into account. When you buy earnings, the number that counts is the fraction of earnings that gets back to you as an investor through dividends and capital gains. Sure, some big investors don’t have to worry about taxes — but at least half of investors do: Taxes really affect valuations. Think about it: If taxes were 100%, no amount of earnings would make you buy stocks!

The tax cut that was passed into law this May made earnings much more valuable to many investors. To keep it simple, let’s say a company paid out all of its earnings in the form of dividends. Under the old tax rates, you’d be taxed at a top rate of about 38% — so a dollar of earnings was only worth 62 cents to you. But now, the maximum tax on dividends is only 15%. A dollar of earnings is now worth 85 cents to you.

Let’s say you were valuing that stock under the old tax rate, at the average P/E of 15: You’d be willing to pay 15 times 62 cents for that stock — or $9.30. But now, under the new rates, you’d be willing to pay 15 times 85 cents — or $12.75. Now, if you saw that stock trading at $12.75, but were still thinking about the after-tax dividend of $0.62, you’d think that stock had a P/E of 20 — and you’d think it was overvalued. But it’s not — you just forgot about the tax cut.

That’s not all that the tax cut will do to valuations. A tax cut on dividends will make companies want to pay out a larger fraction of their earnings in the form of dividends. Since equity valuation is, most fundamentally, the discounted present value of cash flows received by investors, the more earnings that are paid out as dividends, and the sooner they are paid out, the more stocks are worth. If dividend payouts are on the rise, then P/Es deserve to be higher than average.

Second, taxes aside, the other major factor arguing for why P/Es deserve to be higher than average today is interest rates. Again, if equity valuation is the discounted present value of cash flows, then the lower the interest rate, the more investors will be willing to pay for a given stream of earnings from a stock. By the way, I’m not arguing that low interest rates will stimulate the economy and lead to higher earnings, although that is probably true, and only bolsters my case.

To think about interest rates in relation to earnings, turn the P/E upside-down — make it an E/P. That way, you’re looking at earnings as a kind of interest rate — the “earnings yield” you get on the price you pay for the stock. Think of the earnings as being like the income payment on a bond investment — admittedly, a risky bond. Because stocks and bonds trade in the same free market and compete with each other and all other economic opportunities, their yields are — broadly speaking — linked. When the “income yield” of bonds is low, the “earnings yield” of stocks will be similarly low. Now, with bond yields at half-century lows, it’s not surprising to see earnings yields low, too — and thus P/Es somewhat higher than average.

I keep very detailed records of the historical relationship between earnings yields from stocks, and income yields from bonds — and today that relationship stands at nearly historic levels of equity undervaluation. In relation to bond yields, the earnings yield of stocks is just about as cheap right now as at any time in the last 20 years — and that’s not taking any tax effects into account at all.

So if you want merely to look in the newspaper and believe it when you read that the P/E ratio of the S&P 500 is 40 and nothing else matters, that’s up to you. But remember, investing is a complex game — it’s not as simple as a single, superficial statistic. If you look at the numbers beneath the numbers you start to see a very different picture. Stocks start to look tantalizingly cheap.

And isn’t it just wonderful that now only you and I know about it?

Don Luskin is Chief Investment Officer for Trend Macrolytics, an economics research and consulting service providing exclusive market-focused, real-time analysis to the institutional investment community. You can visit the weblog of his forthcoming book ‘The Conspiracy to Keep You Poor and Stupid’ at He is also a contributing writer to

The views expressed above represent those of the author and do not necessarily represent the views of the editors and publishers of Capitalism Magazine. Capitalism Magazine sometimes publishes articles we disagree with because we think the article provides information, or a contrasting point of view, that may be of value to our readers.

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