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Subject:  Re: Evaluating a Stock with a "Higher" Date:  8/12/2008  12:17 AM
Author:  mklein9 Number:  3672 of 3816

I quote a number in the teens, then I'm going to get beat up for throwing out a low ball by those who's expectations are much more myopic.

Hey, don't worry about who's going to think what about your numbers... if they're right, they're right, and anybody who takes issues with you is wrong. Problem in this case for me is, except for within boom cycles, I have *never* heard of anyone quoting average P/Es in the 20-25 range.

The Bespoke chart is useful to look at. One way to interpret it is that until about 1998, we had a century of pretty consistent P/E ranges bottom at about 7 and topping out at about 22. Only in 1998 and beyond have we gone above 22, so it really begs the question why that happened, and whether it's a fundamental shift or not, which leads to this topic:

The reason for the increase over time in historical PE's is simply that we've gradually improved socially or technologically, or both. Once the next paradigm shift kicks in, we can expect another boost and yet another "long term bull market" as you put it. However, it may be a while before that happens.

I personally don't believe "this time it's different" because in any competitive market system, excess valuation (high P/E) is punished due to its inherent risk compared to alternatives, in other words, bubbles popping. We've had a number of those bubbles pop in the last 8 years, and I sure hope we are learning our lessons.

I guess, then, that this implicit assumption -- that you believe there is an inherent structural change that explains and supports higher P/Es going forward -- should be made clear when you quote average P/E numbers like 20-25, IMHO. Maybe you will be proven right, but by no means is that a generally accepted idea today.

If you haven't looked at Crestmont Research's Stock Matrix, it's really quite fascinating. Easterling's book covers the same material in maybe a more easily understandable manner with good explanations. There is likely a danger in assuming permanently high valuations, as many people did with houses, structured investment vehicles, tech stocks of companies with no profits, etc. Eventually, in comparison against other alternatives and when sanity is regained in assessing risk, high valuations falter. By how much is not clear. But stocks at average P/Es of 20-25 are, IMHO, firmly in the camp of overvalued.

That is not to say that an individual stock with a P/E of 25 is overvalued, and you gave some good reasons why. High P/Es are justified if the earnings can be predicted with high certainty to grow at modest rates for a very long time. Coke is a great example, in fact most of Buffett's purchases fall under this category. Those high multipliers come from plugging long growth periods into a DCF or some similar valuation approach. Long periods of compounding growth create tremendous value and high multipliers are justified. But that is the exceptional company, as you noted. Most companies will not pass the sniff test on that kind of valuation.

I would also note on the Bespoke chart, and even more clearly on Crestmont Research's matrix, that once a high average P/E is reached and it starts to fall, it usually falls a long long way, down into the 10 range, through some combination of falling share prices and increasing earnings over time. We are almost certainly in such a period now. It probably has 5-10 more years to play out.

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