Only At the Right Price: P/Es, Dividends, and Value Investing
Malcolm Mitchell - October 2002

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(Special thanks to Laurence B. Siegel for his advice and editing, and for providing the statistical data and charts. The opinions expressed are the author's.)
    The "new-era" doctrine -- that good stocks were sound investments regardless of how high the price paid for them -- was at bottom only a means of rationalizing under the title of "investment" the well-nigh universal capitulation to the gambling fever. . . . The market made up new standards as it went along, by accepting the current price -- however high -- as the sole measure of value.(1)

What investors have to decide, today and into 2003, is this: After the turbulence of the past 20 years, are stock prices now low? Or are they still high?

Let's start with a long-term perspective. Here is the S&P 500 index at several year-ends since 1979:

    1979 -- 108
    1985 -- 211
    1990 -- 330
    1995 -- 616
    1997 -- 970
    1998 -- 1,229
    1999 -- 1,469
    2000 -- 1,320
    2001 -- 1,148
    Oct. 25, 2002 -- 898
This roller coaster of stock prices and the investor losses that resulted are often compared to the 1920s and early 1930s. The fact is, the upside this time was far steeper. We don't know whether we've seen the full extent of the downside, or, if not, when it will be reached. The peak of 1929 was not regained after the crash until 1945.

The feature that is common to both periods is the explanation of what went wrong. The quote above is from a justly famous book, Security Analysis, published in 1934. Yet the words apply equally well today.

In the 1990s, like the 1920s, investors forgot that a company's stock price ultimately depends upon the earnings from its business. When prices were rising, investors didn't ask why; when prices fell, investors didn't understand why. Benjamin Graham and David Dodd explained this too in 1934:

    In theory, of course, [investors] need only follow the old and trite policy of buying when prices are low and selling out when prices are high. No advice could be easier to give or more difficult to follow. High prices and low prices are not marked with distinguishing signals, like red and green traffic lights. Not only are "high" and "low" always relative terms, but in Wall Street their meaning is mainly retrospective.(2)
Especially today, investors need to consider value, and not just price, in trying to decide whether stock prices are low or high. This article argues that the true price of stocks is not the broad index level itself, but rather the index level in relation to corporate earnings.

We'll use two charts to show how stock prices have outrun earnings. Two additional charts will show how corporate dividends contribute less today to investors' returns than ever before.

Buying "Value Stocks" Is Not Value Investing

First, we want to clear up the confusion caused by the invention of "value stocks." They in fact have nothing to do with value investing.

Here's what value stocks are. If two companies each earn $10 per year, but the stock of one is selling at $100 (that is, at a P/E of 10) and the other at $300 (a P/E of 30), the first is called a value stock and the other a growth stock. That's it. "Value funds" select stocks from the lower half of the P/E ranking (where earnings may be replaced by book value or another similar variable); "growth funds" select stocks from the upper half.

A stock's P/E, of course, is determined by several factors, most importantly analysts' evaluations of the company's current and future earnings, and any Wall Street decisions to hype (or downplay) the company or its industry. As we know, analysts can be wrong (intentionally or not), and hype comes and goes. Stock prices are regularly pushed too high or too low, but few investors know for certain which it is.

Value investing, in contrast, is buying stocks only when they are underpriced or fairly priced; a value investor does the analysis necessary to determine which stocks are so priced. They may be found among "value stocks" or "growth stocks" alike. If no underpriced or fairly priced stocks can be found, the value investor buys none at all.

To buy individual stocks or groups of stocks at the right price, investors have to be right about both current earnings and future earnings. That's a tall order for most professional investors, let alone non-professionals.

Happily, applying the principle of value investing to the market P/E is a lot easier.

Chart 1.

The difference between finding the right price for a single stock and finding it for the whole market is that the future of an aggregate index like the S&P 500 can be evaluated on the basis of aggregate current earnings alone. Some individual companies will grow very rapidly in the future, and some others will shrink into bankruptcy. The whole economy, however, is unlikely to do either.

Chart 1 shows that for over 50 years, until the late 1990s, the P/E ratio of the S&P 500, based on most recent reported earnings, remained generally within a range of 10 to 20. During those years, many companies carried P/Es of 50, 100, or more. Many other companies saw their P/Es fall to 1 or 2 before they disappeared. In the aggregate, however, the ratio of stock prices to earnings fluctuated within a much narrower range. (See Note 3 for the derivation of the S&P 500 price, earnings, and dividends, as shown in this and following charts.)

Chart 2.

Chart 2 shows how the spread between stock prices and earnings increased during the 1990s. The increased spread was the cause of the apparent shift of the market P/E into its current range of 20 to 30 that we saw in Chart 1.

Is that upward shift justified? Many professionals see a justification for higher P/Es in a new economic environment, with higher productivity growth, lower inflation, and improved control over economic fluctuations. Some see the fall in corporate dividend payout rates as another justification. (We'll get to dividends in the next section.)

In our view, the ultimate test of all these justifications is whether corporate earnings are growing faster, or at a more stable rate, than was the case for over 60 years. While we can't prove that earnings are not on a faster or more stable track, we can say that there is no firm evidence as yet that they are. Chart 2 seems to show that earnings have been, if anything, more unstable in the past 15 years than previously.

On the other hand, there is a logic in the market P/E ranging around 15. The return we can expect from stocks in general depends upon growth in aggregate corporate earnings. Growth in those earnings should in turn reflect growth in the whole economy, plus any inflation. If we assume 2% to 3% growth in the economy, plus 2% to 3% inflation long-term, then corporate earnings should grow at 4% to 6% annually. Adding dividends (even diminishing dividends), we get to roughly 7% as the long-term return that investors can expect from their stock investments. That 7% return, however, depends on buying stocks at about 15 times current earnings -- 100 divided by 7 is 14.3.(4)

In short, buying stocks at 20 to 30 times earnings is, in our view, paying too high a price. The risk of prices reverting to their historic range of 10 to 20 times earnings is real.

An additional downside risk is evident from Chart 1. Investor pessimism has at some points driven the market P/E below its general range, just as undue optimism has driven it above the range. If the P/E of the S&P 500 begins to move down into its long-term range -- because faster earnings growth doesn't materialize -- investor pessimism may then drag it even further down.

In light of recent well-publicized corporate reporting scandals, we need to add a word on the quality of reported earnings generally. In our view, some scandals, some illegalities, and some divergence between profits reported to shareholders and profits reported to the IRS, have always been part of the Wall Street experience. Yet it is worth recalling that cash earnings are the lifeblood of corporations. Without them, corporations cannot long continue to pay employees, produce their products and services, replace depreciated assets, and grow. (For some companies, like, stock market hype can delay bankruptcy, but not forever.)

As the overall economy grows, most publicly-owned corporations will remain in business, because their cash earnings will in fact grow, or at least remain stable. We believe, therefore, that reported cash earnings do over time provide a reasonably accurate picture of the health of corporations. Investors can safely use aggregate reported earnings as the touchstone for determining when they are buying at the right price.

Having said that, we would also suggest that reported cash earnings are seldom understated. In aggregate, future earnings surprises will probably not be on the upside.

Dividends Are Dead! Long Live -- ??

Chart 3.

Chart 3 shows the sharp drop in the dividend return to investors that began in 1995. The dividend return, or yield, is the dollar amount of dividends divided by the S&P 500 level. It represents the dollar amount of dividends paid during a year to an investor who buys the index that year. When the index climbs rapidly, therefore, the dividend yield may drop, even though the dollar amount of dividends continues to grow. This is in fact what happened between 1995 and 2000, as the chart show.

The loss of dividend yield has not been merely a matter of rising index levels, however. In the first place, Chart 3 shows that the recent drop in the dividend yield is far deeper than ever before. For over 50 years the yield, while fluctuating significantly, remained generally in the 3% to 6% range. For the first time, the yield dropped below 2% in 1996.

Chart 4.

Furthermore, as Chart 4 shows, corporations seem to have made a decision to reduce the dividend payout ratio (corporate dividends as a percentage of corporate earnings). This ratio has also fallen into a lower range. Whereas the payout ratio remained generally in the 50% to 60% range prior to 1970, it has since slipped into the 40% to 50% range. The result is that at times of rapid market appreciation (as began in 1995), the payout ratio now slips even below 40%. The recent (2001-2002) surge in the payout ratio is entirely the effect of lower earnings, not higher dividends.

In aggregate, corporations have been retaining more of their cash earnings than in prior years, intending to reinvest the cash in profitable corporate projects. This has been a pure loss to investors, unless they assume that more cash retained by corporations today will mean more rapid increases in corporate earnings tomorrow. As we said, there is no clear proof that higher corporate earnings growth is in fact happening. For the time being, therefore, investors ought to realize that they have lost a significant portion of their returns on stocks and have gained nothing in exchange.

Are investors who buy the stock market today buying at the right price? Our analyses of the rise in aggregate P/Es and the drop in dividends strongly suggest that the answer is, No.


1. Benjamin Graham and David L. Dodd, Security Analysis: Principles and Technique, McGraw-Hill Book Company, Inc., New York, 1934, pp. 11 & 54.
2. Ibid., p. 321.
3. We obtained S&P index levels, earnings, and dividends from Robert J. Shiller's web site at We then "smoothed" earnings and dividends by calculating the 12-month trailing averages of the numbers reported by Shiller. The P/E ratio is calculated as a given month-end price (level of the S&P 500) divided by the trailing 12-month earnings as of that date. The dividend yield is calculated similarly. The payout ratio is the trailing 12-month dividend divided by the 12-month trailing earnings. Underlying sources for Shiller's data are described on his web site. Note that the S&P 500 began to be calculated in March 1957; prior to that date, data for the S&P 90 are used. The indices are spliced together to form a continuous series.
4. The E/P ratio, or reciprocal of the P/E ratio, is the expected return under stringent conditions (for example, no risk and no growth, as with a nominal Treasury bond). With a positive expected growth rate, the P/E rises (E/P falls) from this level; with risk greater than that of Treasury bonds, the P/E falls (E/P rises). Thus the risk and expected growth of stocks offset each other to some extent, making the E/P ratio a workable first approximation of the expected return from stocks.

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