Market View - June 22

Aggregate "blue chip" stock prices remain significantly above the long term average. The current trailing PE for the S&P500 is 35 times earnings. This is equivalent to an earnings yield of about 2.9% and compares to 6.16% and 6.04% for the 30 and 10 year treasury bonds respectively. Clearly, earnings will have to grow very rapidly in coming years to justify these prices. That does not seem likely at this stage of the business cycle.

The table below demonstrates how high "blue chips" actually are. Curiously, the Tobin Q data is for the market as a whole and it shows a very similar level of overvaluation. First, here's a few useful observations.

The aggregate PE ratio tends to shrink as the business cycle matures. The stock market usually discounts the fact that margins tend to be higher than average late in the cycle. Conversely, PE ratios tend to be higher early in the business cycle when earnings are depressed and a rapid recovery is expected .

Earnings quality is poor at present. The proliferation of stock option compensation has provided management with a tool for keeping and motivating employees. But it has also provided a means of removing a large expense from the bottom line due to the accounting loophole.

Several factors have made book value comparisons more difficult.

1. Accounting changes for post-retirement benefits in the early 90s.

2. A greater willingness on the part of management to write down sub-par assets.

3. More intangible high-tech assets.

I think it's fair to say that stocks aren't as expensive as the price to book value ratio makes them appear, but are probably higher than they look based on prevailing PE ratios. The latter is especially true for companies that are big users of stock options and companies that may be benefiting from bull market economic activity. That includes high-tech companies (stock options), financial services, and some areas of consumption.

From time to time I've talked about stock option compensation and the related accounting loophole that allows earnings at many corporations to be overstated. The current rule, Fas No. 123, recommends (key word recommends) that companies value their employee stock options when they are granted using a standard option model like Black Scholes . The value of options is supposed to be recognized as a compensation expense as they vest in the following years. Unfortunately, very few companies have adopted the new rule. Option information is limited to the footnotes. My personal experience suggests that earnings are often overstated by a much as 5%-10%. I have seen some cases of as much as 25%. Of course there are a lot of disputes and complications about how to value them.

Here are some of the complications:

1. A lot of options have long vesting periods. But for the purpose of pro forma disclosure in the footnotes, companies need only include the effects of options granted in fiscal years beginning after December 12, 1994 and calendar year 1995. Vesting options granted prior to that are not yet being accounted for. Therefore, the full impact of option compensation may not be apparent in the footnotes for several years.

2. In some cases the number of options granted varies sharply from year to year.

3. Multiplying the value of the options granted in any year times the number granted does not take into account variations in the number granted and the likelihood that some options will be forfeited.

4. Another key feature of this rule is that the calculated expense remains the same regardless of what the stock price does in the years that follow. In other words, if the stock price rises dramatically, the expense remains the same even though the value of the reward received by the employee is much larger than expected. Generally what happens is the company repurchases the exercised shares as part of its normal repurchase program and large sums of "owner" money vanish from the balance sheet just in order to avoid dilution.

5. As in #4, if the stock price declines the reverse is true and the options could expire worthless. In practice however, when a stock declines significantly, the options are often repriced in order to deliver the desired compensation level to the employees despite the disappointing stock price performance. This practice adds significant value to the stock options above the original calculations.

FASB is now in the process of drafting new rules to capture the value of repriced options. If an option that was accounted for by Fas No. 123 is subsequently repriced, additional expense will be recognized for the difference between the fair value of the newly modified option and the fair value of the old option. That amount will be recognized over the remaining vesting period. It appears that this expense will not be just recommended. It will be applied.

The section in the footnotes on stock option compensation is usually broken into three part.

One gives the options granted, exercised, forfeited, and average exercise price for each year.

The second gives the weighted fair value of the options granted in each year, the assumptions used to value them, and the pro forma diluted earnings.

The third gives the number of options outstanding and vested for different ranges of exercise prices.

Suffice to say that not looking at the stock option issue is the most important thing for "value investors" to avoid. Despite the complications I highly recommend that serious investors get familiar with the 10K footnotes. All is not as it appears.