Understanding Stock Markets-3

Changes in price-earnings ratios




The price of any stock reflects two dynamic forces: its profit potential and the value the market puts on this potential.




Stock prices often begin to rise before profits begin to grow because the markets "expect" that profits will increase.




Thus, investors are willing to pay a higher P/E multiple for the shares. On the other hand, rising profits are no guarantee that the stock price will continue to move up.




If the rate of profit growth is not up to the market's ex­pectations, then the market will, in effect, place a lower P/E multiple on the issue and the price will drop.




This is termed a multiple correction.




The phenomenon of the multiple correction has trapped many small investors in the stock market.




The trap works something like this: The investor buys a high multiple stock on rumors that profits are likely to continue rising. But not knowing how to interpret the high multiple, the investor fails to bail out in time when growth rates are dampened by, say, anti-inflationary monetary policies.




The perfect situation is a sleeper stock with an unsuspected earnings potential and a low multiple.




The odds are that its stock price will rise much faster than its profits once investors discover its new horizons.




Their buying will push up the P/E multiple.




Now, what is a low multiple and what is considered a high multiple: Historically, the average P/E of stocks covered in the Standard & Poor's Composite Index ranges from about 5 to 25 times average annual earnings.




There is a wide variance within various industrial groups and within the other major groups. High-technology stocks often trade as much as 50 times their earnings per share or more, while bank stocks have traded at 4 to 15 times earnings.




The higher P/E for high-tech stocks indicates the speculative expectation that data processing demands, micro-circuitry development and the accelerating use of computer hardware and software will create rapid and substantial growth in the profits of these companies.




The low P/E for bank stocks reflects the market's view that this industry's growth is slowing and that investors expect no immediate improvement. However, it could also indicate an overlooked stock or perhaps a temporarily out-of-favor one.