Sophisticated investors use the dividend/discount model to determine fundamental value of stocks. Most investors, however, simply determine an appropriate price/earnings (P/E) ratio and apply it to earnings. The P/E is a composite metric of expected growth and the risk of actually realizing that growth in dividends and/or terminal value. For both individual companies and for the market as a whole, P/E ratios vary far more than is justified by reasonable changes in expectations for future growth rates. Why? Because investors make their decisions based on greed and fear.
Since the mid 1900s, the average P/E of the S&P 500 Index has ranged between a low of around 5 to a high of around 35. This reflects a wide-swinging pendulum of pessimism and optimism about earnings growth and earnings sustainability for the index as a whole. Between 1995 and 2000 the P/E of the S&P increased about 90 percent, rising from 18 to 34, or at a compound growth rate of about 11 percent annually. In that time the market rose at a compound rate of around 20 percent (9 percent growth in combined earnings and dividends—including inflation—plus the 11 percent growth in P/E). More than half the rise in stock prices resulted from rising investor optimism regarding future growth and risk.
Productivity and earnings growth did, in fact, increase, and the economy remained surprisingly healthy. But growth rates for the whole economy did not double as investors were led to believe. Many executives promised double-digit growth rates when average growth could not exceed about 6 percent. However, they provided guidance consistent with their promises, managed and manufactured earnings, and redefined the meaning of earnings when required. As management minimized the perceptions of risk, greed overwhelmed fear, and the second scenario described earlier prevailed.
The three-year decline in the broad averages between 2000 and 2003 is easy to explain. Investors reevaluated actual historical growth rates as a measure of expected future rates. They reevaluated risk when hidden liabilities were discovered. And they reevaluated the confidence they had in executives and the boards of directors that oversee them.
The Alignment of GDP and Corporate Growth
As a practical matter, it is virtually impossible for corporate profits to grow for any extended period at a rate that meaningfully exceeds Gross Domestic Product (GDP). Since 1929, GDP has grown at a compound rate of 6.6 percent, far below the promised double-digit rate that so many corporate executives have promised. In fact, according to John Bogle, corporate profits have actually grown at a rate of only 5.6 percent, rarely growing in any year at less than 4.5 percent and never greater than 7 percent.
Certainly some companies’ growth will exceed market averages. But all companies (or a large sampling of them) will not, and in fact cannot. Over the last several decades, research analysts, basing their forecasts on growth targets and guidance provided by the 500 companies in the S&P 500 Index have predicted their average growth would exceed 11.5 percent. Actual growth was about 6 percent.
So much for the claim that only those few corporate overseers that have been caught are guilty, and everyone else is a victim of the loss of confidence. Maybe many of those companies that have become virtually extinct—Enron, WorldCom, and the myriad dot-coms—went that way because they lacked viable business models and not just because they played the Share Price Game. Still, investors should ask themselves which companies continue to play the Game but just have businesses sufficiently good enough that they can avoid insolvency when their numbers and forecasts come into question.
In addition, the explosion in the number of companies issuing financial restatements indicates that more than a few were cooking the articles. According to an October 2002 U.S. General Accounting Office report, the number of listed companies restating financial statements each year has increased by nearly 250 percent since 1997. It appears that about half of the restatements were prompted by the company, the other half prompted externally.
This is discouraging in light of the SEC’s admission that while it was overseeing the boom of IPOs in the late 1990s, it focused less of its efforts on the financial statements of existing large-cap companies. As the SEC now concentrates on bigger, better-known companies, one might expect more restatements to be triggered.
Corporate Life Cycles
Even with recessions that result in temporary setbacks, the entire economy should grow at a reasonably steady pace as incremental increases in labor and capital fuel growth. The economy works by reallocating capital and labor to enterprises that are succeeding and by depriving resources to companies that are stagnating.
But the actual performance and prospects of companies change constantly. As consumer preferences, industrial needs, and technologies evolve, individual stocks and sometimes entire industries reach an all-time high, then decline, and perhaps become obsolete. There is considerable evidence showing that companies experience a normal life cycle. After launching, they can grow rapidly as they exploit new demand or new technology. As they earn above average returns, competition increases and profitability declines as other companies allocate incremental capital and attract labor to the same activity. Alternative approaches and technology become focused on the opportunity. As a result, demand and supply is balanced, growth rates decline, and risks rise from competition and technological changes, forcing returns on capital to decline—first to average and then to below-average rates. In general, all companies face this threat. They can mitigate it only by successfully and consistently reallocating their own capital and resources to new opportunities. Over long spans of time, records indicate that the chance of continuing rapid growth of a single company appears poor at best.
Of course, the implication of this process is that very few companies grow at super-growth rates for extended periods of time, and companies with high growth rates are almost certain to decline. Because stock prices reflect projected growth rates that are five, ten, or twenty years in advance, an assumption of steady growth at high levels presumes continuing future success in taking business risk, which is uncertain and must be reflected in the discount rate. This is especially significant to an investor if the company does not pay dividends providing a return based on risks successfully taken so that future risks are relatively less critical. It also makes the Greater Fool Theory and the Share Price Game appear even more preposterous.
Stock buyback programs, as described earlier, can be used as a substitute for dividends. Investors who choose not to take some capital off the table by selling into these programs commit even further to the Greater Fool Theory. Ideally, stock-buybacks would be done when the share price was high, allowing investors to sell and take profits at the capital gains rate, which is better than the double taxation that dividends are subjected to. But that’s not the way it has worked recently. Management has announced buybacks when prices dipped, encouraging a rebound. But that meant profit-taking investors were selling at a lower price, which hurt their returns. That’s another sign management has other things on its mind than the good of all shareholders.
Management would execute buybacks when prices dipped, encouraging a rebound. But that meant profit- taking investors were selling at a lower price, which hurt their returns.
The Share Price Game, however, hides declining growth and maintains investors’ perceptions of continuing future growth while obfuscating risks. This results in sudden, unpredictable, and very steep declines in price when investors realize that:
- historically reported growth was not real growth
- previously reported earnings were inflated
- current real earnings are much lower than investors were told
- management has been focusing on short-term reported results instead of long-term value creation and the reallocation of resources to new opportunities