Flows of funds and anticipated rates of return are more important than corporate earnings in determining overall stock prices, as my Sept. 30 column showed. The same perspective works for individual common stocks, too.
The basis for the money-flow argument is that corporations and individuals put their most important funds into their businesses, and only after these needs are satisfied do they purchase financial assets.
Therefore, when the economy is strong, there is relatively little money for stocks and bonds. When the economy is weak, there is much more available.
Then there is the concept of expected base rate of return. Investors demand a certain return on their money, regardless of where it is invested.
In strong economies, the rate rises because corporations are able to make good profits on inventories and capital expenditures. Therefore, they are willing to pay a high price for money to invest in these activities. In weak economies, profits on economic investment are low, and so are money rates.
Treasury Bond Proxy
The expected base rate of return is best represented by the yield on an intermediate Treasury bond, with an average maturity of 7.5 years. The reciprocal of this number (1 divided by the yield) has for at least the past 34 years been relatively close to the price-earnings multiples on common stocks.
In essence, the earnings yield on common stocks -- another name for the P/E reciprocal -- is about the same as the yield on an intermediate Treasury bond. And both these numbers are believed to be the same as the expected base rate of return demanded by investors when they put money into financial assets.
Thus, projecting the P/E on a common stock is more important than projecting earnings in determining where an individual stock price will go. Further, the price-earnings multiple is a function of expected rates of return.
Establishing the price-earnings multiple for the overall stock market is not easy because it requires investors to accurately project interest rates.
Projecting the P/E for an individual stock is considerably more difficult. It is more art than science and requires a reasonably accurate projection of future returns on equity, which is the same as the expected rate of return for the company.
This number, adjusted for risk, must correspond to the expected return on the market, or the intermediate Treasury bond.
Theoretically, the relationship between a company's expected return on equity, compared with the return on equity of the S&P 500, should equal the differential between that company's stock multiple and the multiple of the S&P 500.
Determining the expected return on equity is not easy, either. Investors in biotechnology companies believe that in a 7 1/2-year period -- the intermediate Treasury maturity -- they will be paid back many times their original investment.
Different Measure Required
These stocks, therefore, have no current earnings and sell at high prices. They sell at multiples of revenue per share on the expectation that there will ultimately be substantial earnings per share and an above-average return on equity.
Investors in banks do not believe they will get back their money in 7.5 years. History has demonstrated that it is difficult for these companies to achieve, let alone sustain, returns on equity of 13.4%, which is the average return on S&P 500 companies for the past 15 years. Therefore, these stocks sell at price-earnings multiples well below the S&P 500.
Fortunately, the stock market itself provides guidance as to what the price-earnings multiple should be on an individual common stock. This is because over time each industry group has already been accorded a price-earnings multiple (or price-to-revenues multiple, if necessary).
This multiple reflects the expectations of millions of investors concerning rates of return over the years as they have attempted to analyzed the companies in question.
Price-earnings multiples have already been set relative to the P/E on the S&P 500. The relationship of these multiples to the S&P multiple changes very slowly if the industry in question is large and has been analyzed over a long period -- e.g., banking. The multiple relationship can change rapidly for small, newly analyzed sectors -- e.g., biotechnology.
Volatility is inversely related to size and age. The P/E beta, a measure of volatility, on the stocks of new, small companies is in variably higher than that applied to the stocks of older, larger companies.
When attempting to establish the multiple for an individual common stock, the first step must be to determine the P/E multiple of that company's industry relative to the P/E of the S&P 500.
The next step is to determine if there have been developments in the industry suggesting that the industry multiple will change relative to the S&P 500.
It is always best to assume that multiple relationships will not adjust. Remember, millions of investment decisions concerning rate expectations set the existing relationships.
In determining the multiple on an individual company's stock, simplicity counts. This is because complexity generates uncertainty, and uncertainty lowers the expectations of future returns. Strong expectations can only be based on certainty.
A company with a consistent history of high returns will generally have a higher multiple than a company with an erratic past. A strong balance sheet will be accorded a higher multiple than a weak balance sheet.
A company with a simple product line will have a higher multiple than a company with many product lines, despite the attractiveness of the multiple offerings. A single-industry company will generally be accorded a higher multiple than a multi-industry company.
While there are exceptions to any rule, the point is that within any industry, the companies that are the simplest to analyze will have the highest multiples (assuming they have attractive outlooks) because investors can develop conviction concerning the future rates of return.
State Street vs. Chemical
Chemical Banking Corp. will always sell at a lower multiple than State Street Boston Corp., even if both had equally attractive products, because as basically a one-product bank, State Street is easier to understand than multifaceted Chemical.
Bankers Trust New York Corp. will never attain the multiple of Wilmington Trust Corp. because the outlook for Bankers Trust's trading and corporate finance businesses is much more difficult to fix than is the outlook for Wilmington's trust specialty.
While the importance of earnings on stock prices is thought to be less than the other factors discussed, earnings do have a meaningful impact on a stock's price for two reasons:
* The price of the stock is based on a multiplication of its earnings by its base rate reciprocal (P/E).
* The company's projected earnings growth rate helps define its stock's P/E.
For example, assume investigators are seeking an 8% return on their funds, and that the stock is to be sold in 7.5 years with a terminal multiple of 15 times earnings.
In this case, a company with an expected growth rate of 2% would have a calculated price-earnings multiple of 14.6. A company with an expected growth rate of 10% would have a calculated multiple of 21.2.
Source of Confusion
This is what causes confusion about the role of earnings in determining stock prices. It is clear that the expected growth rate of earnings helps determine the P/E. Further, it is just as evident that in good economies, projected company returns go up.
The valuation conflict comes from the pull between the investors' demanded rate of return, which is rising at this time also, and the company's more positive earnings growth outlook.
Between the two, the number that fluctuates faster and by the greater magnitude will set the tone for the stock.
In general, for large companies such as banks, this is the demanded rate of return. For smaller organizations, it is the earnings growth rate.
For the market as a whole, the defining number is the demanded rate of return.
While bankers will continue to stress earnings in their comments to investors, they should heed these other considerations.
The stories they tell must be simple. The projected company returns on equity must be high relative to their industry group, and on a risk-adjusted basis to the market.
Investors, on the other hand, when picking bank stocks, should focus, in this order, on:
* Factors affecting Treasury yields.
* The projected price-earnings multiples for all common stocks.
* The relationship of projected banking industry returns on equity to the expected returns on equity for the market.
* Where the individual bank's returns are expected to be, compared with the industry.
* What the company will earn.
Mr. Bove is a banking consultant with the Bove Group in Chatham, N.J.