P/E: Future on the Horizon

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This article original appeared on Doug Short’s site, www.dshort.com. It is a must-read follow-on to a two-part series by Ed Easterling. It discusses the ability of the Crestmont methodology for P/E and EPS, unlike other methods, to provide forward-looking insights for investors. Here are links to the previous articles: P/E: So Many Choices, Part I and Part II.

Ed's books, Unexpected Returns and Probable Outcomes, have Doug’s unqualified endorsement for anyone trying to understand the complex and often puzzling relationship between the economy and the market.

When you embark on a trip toward a desired destination, it is important to know your starting point and the path that you will take. For every investor, the destination is financial success. Wouldn't it be helpful to have a financial planning GPS, especially one with updates about market corrections to help you detour around the snarl? The reality, however, is that no such magic device exists and investment success requires old fashioned discipline and judgment.

Discipline starts with an assessment of the environment and a map of the journey. Ptolemy, a famous cartographer and astronomer almost 2000 years ago, drew horizontal and vertical lines around the globe to enable seafarers to navigate unknown waters using tools of the time. He created the parameters and framework that enabled ship captains to see their futures on the horizon. They no longer were destined to follow a path of hope; they could have strategies that empowered direction with insight.

The principles

Conventional wisdom holds that long-term forecasts of the stock market must be impossible because "even its short-term predictability is challenging." If you can't reasonably know what will happen next week or next year, how on earth are you to know what will happen next decade?

2004 forecast vs. 2011 Well, there's a simple lesson from the forest. There are many factors that impact the growth of trees each year: rain, sun, temperature, and a host of other conditions.

Ask any forester; all of those conditions make it impossible to accurately predict tree growth for any given year. Yet ask that same forester about the next decade and she will reach for the historical tables. They provide standards for tree growth over long-term decades. When a tree is ultimately cut and its rings are measured, the year-to-year variances average out to prove the reliability of the historical tables.

But every tree does not grow at the same rate under all conditions. The universal "average" is a fallacy. For example, trees of the same species grow at slower rates when confronted with altitude, colder temperatures, and reduced rainfall. Likewise for the stock market, it does not generate the mythical 10% average return under all conditions. There are fundamental principles and factors that cause stock market returns.

Stocks are instruments of ownership in companies that generate profits over time. Stocks are financial assets that have value because of future cash flows in the form of dividends and earnings. Today's value for a stock, and the stock market overall, is driven by future earnings growth and market rates of return.

It's almost that simple: if you can assess the likely growth rate for earnings and have an estimate for market rates of return, then forecasting the future of stock market returns is clearly on the horizon.