Monday, April 9, 2007

Are P/E Ratios Important?

Lately there has been many analysts talking about how the market is undervalued because the market's P/E ratio is below is historical moving average. This can be seen in the first chart which compares the price to earnings ratio and the price to dividend ratio of the S&P 500. A market is not a buying opportunity just because its P/E ratio is low. There are reasons why the P/E ratio is below its historical trend line, and will continue to stay below that level.

Today, Dow Chemical and Burlington Northern are both in the news. Burlington because it was announced that Warren Buffet has raised his stake in the company to over 10% and Dow Chemical because it is being taken private in an estimated 50+billion dollar leveraged buyout. Do you think these two companies were targeted because they had a low P/E ratio? Revenues in Dow Chemical were 49billion last year and the company earned $3.82 a share, with around 960million shares outstanding. Its average dividend over the past 5 year is 3.4%.

This deal can make sense for many reasons. If you have a lot of cash, and can borrow even more and pay a low interest rate, you can leverage your money to not just invest in certain companies, but buy specific ones entirely. What might make sense today could not be a good deal tomorrow, but if you buy solid companies that have their own steady revenue stream you can make a lot of money. With low rates, the returns on deals like this are in excess of 20% because most of the money is borrowed. Does the fact that these deals are taking place mean that the market is ready for another leg up and the bull market has a green light? Does it mean that capital that might have gone into our bond market is looking to go else where? Are rates going to keep going up, because global demand for goods and services is going to expand even if domestic growth stalls or slows?

The effect of these buyouts can be looked at many ways. The money that is now going into Dow Chemical and other LBO's isn't going to be going into other equities or bonds, but that money is mostly leveraged so that might not be as important. The pension funds and mutual funds that are now selling Dow Chemical into the deal, now have capital that they are going to reinvest in other equities, this should be a plus for the market.

Back to the idea of P/E ratios. Over the past years as companies come out of the S&P 500, new companies are added. Basic materials and energy companies have been the best performers over the past few years and the S&P has increased their weighting in the index. These stocks normally have lower P/E ratios compared to technology stocks or other high fliers of the last bull market that have since faded.

The chart below shows the dollar index and two commodity based stocks;Anadarko Petroleum Corporation and US Steel. Anadarko has a P/E of 4.24 and US Steel 9.19. These stocks have had great runs, and yet their P/E ratios are not anywhere near the average for the S&P 500. The chart below shows the point at which the US Dollar started to decline. As this decline started to get some steam, commodity stocks started to preform better than the market as a whole. At first they might have just been compensated for having a commodity based business and the dollar going down required their hard assets to go up in price, but then China was recognized as a growing economy that was consuming more and more of the world's raw materials to fuel their growth. This has lead to basic material(metals and oil)companies, around the globe, to outperform just about any other sector. This trend doesn't seem to be ending yet, and there should be some growth numbers out on China's economy this week.

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