. 106
( 193 .)


P/E Ratios and Stock Risk
One important implication of any stock valuation model is that (holding all else equal) riskier
stocks will have lower P/E multiples. We can see this quite easily in the context of the constant
growth model by examining the formula for the P/E ratio (Equation 12.8):
P 1 b
E k g
Bodie’Kane’Marcus: IV. Security Analysis 12. Equity Valuation © The McGraw’Hill
Essentials of Investments, Companies, 2003
Fifth Edition

The Great Divide: New vs. Old Economy

The stock market has divided the world into two camps: about the levels certain technology stocks have reached?
In a matter of months, some of the new-economy com-
new-economy companies and old-economy companies.
panies have achieved greater market valuations than
The gulf between them could not be wider.
New-economy companies do technology, including some of their well-established old-economy competitors
the Internet. Old-economy companies do everything despite smaller or nonexistent earnings. (See table.)
else. The stocks of new-economy companies command Do these staggering valuations make sense? They
don™t if you think that the new economy is not quite as
[in 1999] tremendous price“earnings ratios, anywhere
from 70 for Microsoft to 450 for America Online. Old- new as its advocates would like to believe. Consider
economy companies have ordinary multiples in the 10 competition, for example. Lucent Technologies and
to 25 range. A higher multiple reflects greater opti- Cisco Systems are two of the hottest firms in technol-
mism about a company™s future earnings. ogy. Both stocks sell at huge multiples to earnings. Yet
On some level the gap reflects an underlying reality. the two companies are gearing up to go head-to-head
The technology sector is growing much faster than the in the market for telephone and data equipment. Won™t
economy as a whole. Analysts expect technology giants the competition depress profit margins in the industry?
like Dell, Cisco Systems, and Intel to increase earnings And what about those old-economy companies?
at a 20 to 25 percent pace; corporate earnings overall Might not some of them jump into the Internet world
are expected to grow at about 6 percent annually. and fight successfully to protect their market share?
But isn™t it possible to accept the basic notion that The world is more complex than the market currently
technology is changing the world and still be skeptical suggests it is.

Market Values of Old-Economy versus New-Economy Firms
Industry Company Market Cap 1998 Earnings

Old Finance Paine Webber $6.2 billion $473 million
New E-Trade 10 billion 0
Old Retail Sears 17 billion 1 billion
New Amazon.com 30 billion 124 million
Old Transportation United Airlines 4.1 billion 821 million
New Priceline.com 10 billion 112 million
Old Auction Sotheby™s 1.9 billion 45 million
New eBay 22 billion 2.4 million

NEWSPAPER CO (MA).Reproduced with permission of GLOBE NEWSPAPER CO (MA) in the format Textbook via Copyright Clearance Center.

Riskier firms will have higher required rates of return (i.e., higher values of k). Therefore, their
P/E multiples will be lower. This is true even outside the context of the constant growth
model. For any expected earnings and dividend stream, the present value of those cash flows
will be lower when the stream is perceived to be riskier. Hence the stock price and the ratio of
price to earnings will be lower.
Of course, if you scan The Wall Street Journal, you will observe many small, risky, start-
up companies with very high P/E multiples. This does not contradict our claim that P/E mul-
tiples should fall with risk: Instead, it is evidence of the market™s expectations of high growth
rates for those companies. This is why we said that high risk firms will have lower P/E ratios
holding all else equal. Given a growth projection, the P/E multiple will be lower when risk is
perceived to be higher.
Bodie’Kane’Marcus: IV. Security Analysis 12. Equity Valuation © The McGraw’Hill
Essentials of Investments, Companies, 2003
Fifth Edition

434 Part FOUR Security Analysis



P/E ratio
P/E ratio





1955 1958 1961 1964 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000

F I G U R E 12.4
P/E ratio of the S&P 500 Index and inflation

Pitfalls in P/E Analysis
No description of P/E analysis is complete without mentioning some of its pitfalls. First, con-
sider that the denominator in the P/E ratio is accounting earnings, which are influenced by
somewhat arbitrary accounting rules such as the use of historical cost in depreciation and in-
ventory valuation. In times of high inflation, historic cost depreciation and inventory costs will
tend to underrepresent true economic values because the replacement cost of both goods and
capital equipment will rise with the general level of prices. As Figure 12.4 demonstrates, P/E
ratios have tended to be lower when inflation has been higher. This reflects the market™s as-
sessment that earnings in these periods are of “lower quality,” artificially distorted by infla-
tion, and warranting lower P/E ratios.
Earnings management is the practice of using flexibility in accounting rules to improve
the apparent profitability of the firm. We will have much to say on this topic in the next
chapter on interpreting financial statements. A version of earnings management that has be-
The practice of
come far more common in recent years is the reporting of “pro forma earnings” measures.
using flexibility in
These measures are sometimes called operating earnings, a term with no generally accepted
accounting rules
to improve the definition.
apparent profitability Pro forma earnings are calculated ignoring certain expenses, for example, restructuring
of the firm.
charges, stock-option expenses, or write-downs of assets from continuing operations. Firms
argue that ignoring these expenses gives a clearer picture of the underlying profitability of the
firm. For example, many companies incurred major expenses associated with the September
11 attacks, and rightly claim that it is useful to examine what their financial results would have
been without those unusual expenses. Comparisons with earlier periods probably would make
more sense if those costs were excluded.
But there is currently so much leeway for choosing what to exclude that it becomes hard
for investors or analysts to interpret the numbers or to compare them across firms. The lack of
standards gives firms considerable leeway to manage earnings. One analyst calculates that in
the first three quarters of 2001, the companies that comprise the Nasdaq 100 index reported
Bodie’Kane’Marcus: IV. Security Analysis 12. Equity Valuation © The McGraw’Hill
Essentials of Investments, Companies, 2003
Fifth Edition

12 Equity Valuation

collective pro forma earnings of $82.3 billion, but GAAP losses of $19.1 billion, a difference
of over $100 billion”for only these 100 firms.6
Even GAAP allows firms considerable discretion to manage earnings. For example, in the
late 1990s, Kellogg took restructuring charges, which are supposed to be one-time events, nine
quarters in a row. Were these really one-time events, or were they more appropriately treated
as ordinary expenses? Given the available leeway in managing earnings, the justified P/E mul-
tiple becomes difficult to gauge.
In the wake of the accounting questions raised by the Enron, WorldCom, and Global Cross-
ing bankruptcies, there seems to be a new focus on transparency in accounting statements.
Firms with difficult-to-interpret statements suffered substantial stock market losses in the first
months of 2002. The market clearly has established a new focus on quality of earnings.
Another confounding factor in the use of P/E ratios is related to the business cycle. We were
careful in deriving the DDM to define earnings as being net of economic depreciation, that is, the
maximum flow of income that the firm could pay out without depleting its productive capacity.
And reported earnings, as we note above, are computed in accordance with generally accepted
accounting principles and need not correspond to economic earnings. Beyond this, however, no-
tions of a normal or justified P/E ratio, as in Equation 12.7 or 12.8, assume implicitly that earn-
ings rise at a constant rate, or, put another way, on a smooth trend line. In contrast, reported
earnings can fluctuate dramatically around a trend line over the course of the business cycle.
Another way to make this point is to note that the “normal” P/E ratio predicted by Equation
12.8 is the ratio of today™s price to the trend value of future earnings, E1. The P/E ratio reported
in the financial pages of the newspaper, by contrast, is the ratio of price to the most recent past
accounting earnings. Current accounting earnings can differ considerably from future economic
earnings. Because ownership of stock conveys the right to future as well as current earnings, the
ratio of price to most recent earnings can vary substantially over the business cycle, as account-
ing earnings and the trend value of economic earnings diverge by greater and lesser amounts.
As an example, Figure 12.5 graphs the earnings per share of Sun Microsystems and Con-
solidated Edison since 1986. Note that Sun™s EPS fluctuate considerably. This reflects the
company™s relatively high degree of sensitivity to macroeconomic conditions. Value Line es-
timates its beta at 1.25. Con Ed, by contrast, shows much less variation in earnings per share
around a smoother and flatter trend line. Its beta was only 0.75.
Because the market values the entire stream of future dividends generated by the company,
when earnings are temporarily depressed, the P/E ratio should tend to be high”that is, the de-
nominator of the ratio responds more sensitively to the business cycle than the numerator. This
pattern is borne out well.
Figure 12.6 graphs the Sun and Con Ed P/E ratios. Sun, with the more volatile earnings
profile, also has a more volatile P/E profile. For example, in 1989 and 1993, when its earnings
were below the trend line (Figure 12.5), the P/E ratio correspondingly jumped (Figure 12.6).
The market clearly recognized that earnings were depressed only temporarily.
This example shows why analysts must be careful in using P/E ratios. There is no way to
say a P/E ratio is overly high or low without referring to the company™s long-run growth
prospects, as well as to current earnings per share relative to the long-run trend line.
Nevertheless, Figures 12.5 and 12.6 demonstrate a clear relationship between P/E ratios
and growth. Despite considerable short-run fluctuations, Sun™s EPS clearly trended upward
over the period. Its compound rate of growth in the decade ending 1999 was 30%. Con Edi-
son™s earnings grew far less rapidly, with a 10-year compound growth rate of 2.3%. The
growth prospects of Sun are reflected in its consistently higher P/E multiple.
This analysis suggests that P/E ratios should vary across industries and, in fact, they do.
Figure 12.7 shows P/E ratios in late 2001 for a sample of industries. P/E ratios for each

Reported in The Economist, February 23, 2002, p. 77.
Bodie’Kane’Marcus: IV. Security Analysis 12. Equity Valuation © The McGraw’Hill
Essentials of Investments, Companies, 2003
Fifth Edition

436 Part FOUR Security Analysis

F I G U R E 12.5 6
Earnings growth for
two companies
Earnings per share (1994



















. 106
( 193 .)