Choosing Your Investments: What To Do When “Quality” Is Bad
By Dr. Steve Sjuggerud, President, Investment U
Thursday, April 3, 2003: Issue #227
I feel pretty darn good…
For a new father that hasn’t had a proper night’s sleep in two weeks, I’m pretty close to 100% today. How is that possible? I don’t know. But I do know that when I do hit the sheets, I crash hard. I’m OUT.
It must be about the quality of that sleep, because it’s sure not the quantity – even though the number of hours of sleep I can report to you have fallen, the quality of that sleep is very good.
When sizing up an investment, “quality” matters as well. It’s not just the numbers you see in front of you. Before you invest, you also have to ask, “Just how good are those numbers?” It turns out, when it comes to corporate earnings, those numbers are not so good. The quality stinks.
When Bad Becomes Worse… 61% Worse!
Here’s what I mean: The stock market right now is trading at a price-to-earnings ratio of about 31. Based on that number, stocks are more expensive than they were at the stock market peaks in 1929 and the late 1960s. However, according to this week’s Barron’s magazine, that number is no good
For example, Cisco’s “official” price-to-earnings ratio is 34.6. That’s pretty high. But it gets even worse – if you include employee stock options as an expense, the true number becomes 71.1. Ouch! And Cisco is more the rule than the exception when it comes to this – Barron’s shows that, when stock option grants are accounted for, earnings at tech companies would have been 61% lower than they reported in 2002.
There is still some contention over whether or not granting employee stock options is a compensation expense. Consider the case of Cisco’s CEO, John Chambers. Chambers worked for a $1 salary (compensation) last year – or at least that’s what shows on Cisco’s books. The poor man how could he even put food on the table?
Why would he accept such a compensation package? Because $1 in pay was only part of his deal – the rest included 4 million options granted to him last year. According to a recent issue of Forbes, when you add it all up, Chambers has been compensated $280 million over the last five years, and has $40+ billion worth of Cisco stock. Clearly, even on a $1 salary last year, he gets by. Somehow, Chambers has amassed a $40 billion fortune in Cisco stock. But it didn’t show on 2002′s books.
Whether you think this is right or not doesn’t matter – because it looks like it will change for 2004. Companies must include option grants as an expense starting that year.
Stocks Are Even More Expensive Than Many Think
Standard & Poor’s, keeper of the S&P 500 index, has done a noble job of trying to keep up with shenanigans to get down to what it calls “core” earnings (among other things, S&P counts stock options as an expense when calculating core earnings). S&P says that the price-to-”core” earnings ratio is around 37+.
People debate whether or not S&P’s core earnings figure is the right one to use. Whether it is or not, the fact remains that, from what companies tell us, stocks are expensive. And from what they choose not to tell us (about stock option grants to executives for example), stocks are an even worse deal for us as investors.
The sheer number – the “quantity” – of the price-to-earnings ratio is high. Even worse, the “quality” of that number is in question.
Therefore, the best action is likely to tread carefully in stocks in near future. Doing so may give you a better quality of sleep at night.
Good investing,
Steve
Today’s Investment U Crib Sheet
Looking at how much you’re receiving in earnings – via a price-to-earnings ratio – is one of the most time-tested ways to determine the “right” price of a stock. To learn more about this and other fundamental measures of value, please see IU E-Letter #102: The “Right” Price For Any Investment.
Related Investment U Articles:
- Cash Flow: One of the Most Accurate Ways to Analyze a Stock’s Value
- Be the Pit Boss of Your Own Options Casino
- Stocks Are the Cheapest in 15 Years… And Here Are Three Big Bargains
- Will Apple Boost This Semiconductor Company?
- The Best Way to Measure Company Performance
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