Are Traditional Measures Of Market Values Obsolete?

0scar Wilde defined a cynic as one "who knows the price of everything and the value of nothing." The playwright's comment touches on a central problem for investors. In financial markets, it's easy to know the price of a security- stock prices are quoted throughout the trading day, and newspapers print closing prices each day. But value is a trickier concept. How is an investor to know whether current prices-of individual securities or the overall market represent good value or overpriced merchandise?

Over time, various measures have been developed to help investors gauge the relative value of investments. This article addresses some key benchmarks and their current relevance.

P/E Ratio: What Price Profit?

The price/earnings ratio, or P/ E, is the stock market's best-known value barometer. It is calculated by dividing a stocks current price by the per-share earnings, or profits, of its issuing company. The P/ E ratio can be thought of as the price investors are willing to pay for $1 in corporate earnings. If a company reports annual profits of $2 per share and its shares sell for $40, its P/ E ratio is 20 to 1, or 20. The P/ E in newspaper stock listings is based on "trailing" earnings-the net profits reported over the previous four quarters. However, securities analysts and investment managers often calculate P/ E ratios based on a company's projected earnings for the upcoming year.

Earnings are linked to a company's stock value because they provide the financial fuel for expansion and the wherewithal to pay cash dividends to shareholders. Ultimately, a company's stock price will rise or fall along with the earnings it generates.

The long-term average P/ E ratio for U.S. stocks, as represented by the Standard & Poor's 300 Composite Stock Price Index, is about 15. Since World War II, this ratio has fluctuated from a low of about 6 (in 1949) to a high of 26 (in 1991). The S&P 500 Index on September 30, 1997, traded at about 23 times trailing earnings- high by past standards, especially considering that the U.S. economy is in the seventh year of an expansion.

Dividend Yield: Bird In The Hand

Dividend yield measures a stock's annual dividend payment as a percentage of its current price. It is viewed as an important value indicator because, over the long haul, dividends and growth in dividend payments have been driving factors in common stocks' returns.

Because dividends are cash that can be spent or reinvested now, they can be thought of as a "bird in the hand." Price appreciation- the other source for total return on stocks-is a "bird in the bush" because there is no certainty that price increases an investor anticipates will actually occur.

The dividend yield can be thought of as the level of current income that investors are willing to accept per investment dollar. Dividend yields tend to be low when inflation and interest rates are low and investors are optimistic about future prospects for stocks. Yields tend to be high when investors are pessimistic about the stock market or when inflation and interest rates are high.

Among individual stocks, dividend yields often vary widely across business sectors. Companies in mature or heavily regulated industries, such as utilities and banks, tend to offer relatively high dividend yields. Young, fastgrowing companies often pay no dividends at all, retaining profits to finance expansion.

The long-term average yield of the S&P 500 Index is about 4%, equivalent to a price of about $25 per $1 of annual dividend income. Since 1926, the overall market's dividend yield has at times exceeded 10%, most recently in 1950. Historically, a dividend yield below 3% has signaled that the stock market was overvalued. A dividend yield above 6% has been regarded as a sign that stocks were generally cheap.

The yield on the S&P 500 Index was near a record low of about 1.6% on September 30, 1997, meaning that investors were paying, on average, more than $62 for each $1 of dividends.

Price-To-Book Value

Another gauge is to compare the price of a stock with its book value, the per-share net worth of the company. Net worth is what remains after a company's current bills and longer-term debt are subtracted from its assets (cash, inventory, equipment, buildings, etc.). The Standard & Poor's Industrial Index as of September 30 was trading at more than five times the book value of the underlying shares of stock, more than twice the average over the past 20 years.

Are Benchmarks Obsolete?

The usefulness of traditional value benchmarks is under question because many of them have been signaling that stock prices were over-valued for several years, even as stocks have continued to rise. Optimistic investors contend that prices are reasonable because conditions are so good for common stocks: low inflation, low interest rates, solid economic growth, rising corporate profits, and thriving global trade. Others argue that speculative buying has inflated stock prices, and that today's ideal conditions already are reflected in the tend to move prices. When conditions become less ideal, they in the opposite say, the stock market will stumble.

Today's record low dividend yield is not so worrisome, some analysts say, because interest rates on competing fixed-income investments are relatively low and companies are less inclined than in the past to pay dividends. With a strong economy, the reasoning goes, companies are wise to invest spare cash to expand production or to improve operating efficiency.

In addition, many investors place less emphasis on dividends now than in the past, partly for tax reasons: Dividends are taxed as ordinary income, at rates as high as 39.6%, while price gains from the sale of assets held for more than 18 months are subject to a maximum capital gains tax rate of 20%. The tax advantage of capital gains over dividend income has prompted some companies with extra cash to use the money to repurchase shares of stock in the open

market instead of increasing cash dividends. By reducing the supply of shares, these companies hope to boost the price of remaining shares.

Whereas circumstances may have altered the "danger zone" for some valuation measures, historical yardsticks still have meaning, said Ian A. MacKinnon, Managing Director and head of Vanguard Fixed Income Group. "It may be that price-to-book isn't as relevant anymore, or that price-to-dividends isn't as relevant anymore, but the stock market is also richly valued on other measures that are still important: cash flow, earnings, and sales," he said.

A Vanguard Valuation Approach

Vanguard's Personal Advisory Services (PAS), which provides ongoing investment advice to clients, recommends minor reductions in clients' equity holdings when stock prices appear seriously overvalued.

The PAS approach compares expected returns on common stocks (based on current and expected dividends and earnings) with the risk-free yield available on U.S. Treasury bills to determine how much of a premium investors are receiving for taking the risks inherent in owning stocks. At the end of September, PAS was recommending that investors trim slightly their allocations to stocks, said Michael Odlum, Principal and director of PAS. For example, if a client's recommended allocation is 65% stocks and 35% bonds, a change to 60% stocks and 40% bonds may be advised.

"Investor expectations about future stock returns are fairly high," Mr. Odlum said. "A lot of valuations now are based on the idea that earnings will rise substantially in 1998 and for several years thereafter. But there is some doubt whether earnings growth will be sustained long enough to justify these expectations."

He emphasized that each investor's case is unique. Before changing allocations, tax implications must be considered. For some clients, he said, capital gains taxes on stocks sold in order to reallocate would be too high to justify the risk reduction that the reallocation is designed to achieve.

Even when stock prices appear to be overvalued, Mr. Odlum said, the allocation to stocks should seldom vary much from an investors long-term target. "A well-diversified, long-term investment program should include a reasonable mix of stocks," he said. "Investors should be ready to 'stay the course' through market ups and downs to achieve investment growth over time."