Potential distortions are created because investors’ myopia, caused by their inability to forecast accurately expected earnings in perpe-
tuity, is embedded in the P/E valuation model. The Equation (3) valuation framework time horizon truncates to a single-year expected earnings while the common stock price still reflects the present value of all future expected earnings.
The growth rate in expected earnings for growth stocks is often assumed constant at any time in the P/E valuation model. This lim- its the P/E model. Cyclical fluctuations in expected earnings for business-cycle-sensitive companies are not accurately captured in the single-year P/E valuation model. Earnings deficits, particularly of venture capital stage companies, are not conceptually captured in the P/E valuation model. Companies worth more for their assets than for their earnings capacity cannot be conceptually or accurately valued in the P/E model.
Growth Stocks
The P/E multiple for growth stocks is distorted by the truncation of the Equation (3) valuation framework. The common stock price (P) in the numerator of the P/E multiple reflects all future earnings discounted to the present. In contrast, the earnings (E) in the P/E multiple reflect only relatively current single-year earnings in the de- nominator. The comparison is “apples to oranges.” The price in the numerator reflects the entire future. The earnings in the denominator reflect only a relatively current single year.
The current common stock price of a growth company reflects the cumulative impact of much higher earnings expected years from now. The current earnings are low. The P/E is high. For example, a rapid growth stage company’s expected earnings might resemble:
Year Earnings per Share ($)
1 .01 2 .10 3 1.00 4 4.00 5 8.00 6 16.00 7 32.00
The common stock price might be about $180 based on a 20% required rate of return. The P/E would be 18,000 based on the year 1 earnings, 1,800 based on year 2 projected earnings, and 180 based on year 3 projected earnings. All these P/Es would be considered high by historical average standards. They are not incorrect. They are sim- ply distorted by the P/E truncation of the Equation (3) valuation framework. The common stock price reflects the value from the en- visioned earnings over the life of the company. The P/E valuation model reflects the common stock price relative only to the current earnings. An apples-to-oranges distortion occurs.
The risk in a high P/E multiple growth stock is not necessarily the high valuation but the failure of earnings to meet expectations. Once the growth rate is not maintained, expected earnings in every future year are adjusted down. The cumulative effect is a sharp drop in the common stock price. Of course there is some P/E at which the val- uation is too high even if the expected earnings are realized.
Cyclical Stocks
The P/E truncation of the Equation (3) valuation framework also distorts its interpretation when applied to cyclical stocks. Cyclical ex- pected earnings patterns fluctuate even if generally trending upward. Cyclical common stocks are business-cycle-sensitive and in the ma- ture or stable/declining stage of their industry life cycle. Their P/E may be high during a year of recession-depressed, temporarily low earnings. Investors look beyond the valley in earnings to the earnings recovery. Conversely a cycle stock P/E may be low during expansion- induced, temporarily high earnings. Investors look over the mountain to the next valley in earnings. For example, projected cyclical earnings could be as follows:
Year Earnings per Share ($)
1 .01 2 1.00 3 5.00 4 1.00 5 .01 6 4.00 7 8.00
In this case, the common stock price might be about $48. The P/E would be over 4,800 based on year 1 earnings, 48 based on year 2 projected earnings, and 9.6 based on year 3 projected earnings. The first seems too high. The last seems low by historical standards. They are not incorrect. They are simply distorted.
The cause of distortion in the P/E multiple is the same as for a growth stock. The common stock price reflects all future earnings. The P/E valuation model uses only the current single-year earnings in its denominator. Investors are again faced with the apples-to- oranges comparison.
Deficits
The P/E multiple truncation becomes meaningless when there are no earnings. Earnings in the denominator of the P/E valuation model are negative. The P/E multiple is also negative. Rigid application of the P/E model implies a negative common stock price. This implies selling stockholders must pay buying stockholders to take the shares off their hands. This is illogical. A negative P/E multiple also becomes less negative as earnings deficits enlarge. This is also illogical.
The positive common stock price for a company with a current earnings deficit reflects positive future earnings discounted to the present as in the Equation (3) valuation framework. This is not cap- tured in the P/E valuation model. The P/E is not meaningful for a common stock with a current earnings deficit.
Companies with earnings deficits have no meaningful P/E. Some- times another valuation shorthand is used, such as the price/revenues multiple in the early stages of the Internet stocks. This multiple may have less specific meaning because minority position common stock prices are based on earnings and not revenues. There is little comfort in knowing that because one Internet stock sells for two hundred times revenues, others in the industry must also sell at that multiple of revenues.
Assets
The value of a few companies lies more in the worth of their assets than in the expected earnings generated from those assets. These firms are worth more “dead than alive.” Controlling stockholders can profit by liquidating or selling the assets. Minority position stock-
holders cannot force such a liquidation or sale upon entrenched and intransigent boards of directors. Shareholders may never realize the asset value underlying the shares. The common stock price is based on the expected poor earnings generated from the underperforming assets and is less than the value of the assets themselves.
The same potential distortions exist for any valuation framework that truncates and approximates the Equation (3) valuation frame- work. All valuation frameworks, however, must truncate. Investors simply cannot accurately forecast expected earnings until infinity. No human can. Successful entrepreneurs may correctly envision trends, but they can no more precisely forecast expected earnings than any- one else. Many entrepreneurs correctly forecast the large future trends and succeed. Others fail. Wall Street analysts are rated for the accuracy of their one-year future earnings forecasts. The more ac- curate ones are lauded and rewarded well. However, consistent ac- curacy is not one of their common characteristics.
Investors must recognize the potential P/E distortion and the as- sociated risks and valuation implications. Investors must also respond appropriately. For example, many investors diversify.
GENERAL STOCK MARKET BUBBLES AND