What Price Profits?

Ultimately, what an investor pays for when he buys stock is a share of the profits that a company makes. But how much must he pay for the right to claim a dollar of the firm's earnings as his own? One answer lies in the price/earnings ratio, which is computed by dividing the closing price of a company's stock by its net income per share for the most recent twelve months. If a company earns $2 per share, and its stock sells for $34, its price/earnings ratio is 17. P/E ratios can be figured out by anyone with a pencil, a stack of paper and access to stock-price quotations and quarterly earnings reports --but there is no longer any need to bother. The Associated Press has begun including P/E ratios for every common stock* on the New York and American exchanges in the daily market tables that it sends out. So far, 15 major papers, including the Wall Street Journal, New York Times, Chicago Tribune, Los Angeles Times and Washington Post, carry the figures.

A glance down the columns discloses that the P/E ratios of shares on the New York Stock Exchange reach from a lowly 2 for Horizon Corp., a land developer, to an astronomical 725 for White Motor Corp., the heavy-duty-truck manufacturer. How can an investor make sense out of these seemingly incongruous figures? One key is to realize that a P/E ratio reflects, even more than current earnings, the market's anticipation of future profits.

Stocks of companies with long records of rapid profit growth sell at relatively high ratios, for example, 35 for IBM and 50 for Xerox. P/E ratios are high in such glamour industries as photography, cosmetics and soft drinks. Conversely, shares of companies in cyclical industries--in which profits fluctuate widely--usually sell at a low multiple because buyers must put up with considerable uncertainty about the future. In the auto industry, Ford sells at a humble nine times earnings, and even mighty GM commands a P/E of only 11. Other industries in which ratios are low include steel and textiles.

Factors other than earnings can also affect the price of a stock and wildly distort P/E ratios. Aerovox Corp. earned a grand total of less than 30-c- per share in the last four quarters, but its stock still sells at about 13 1/2 per share, giving it a P/E of 50, because it is in a growth industry--electric and electronic components. Though Superior Oil earned only $1.06 a share in 1971, it sells at a ratio of 251, largely because the market places a high value on its enormous reserves of oil in the U.S. and Canada. Only investigation can determine whether any stock's P/E ratio is too high or too low, but a perusal of those ratios can at least tip an investor which issues may be worth a close look, and give him some rough guides as to what to expect. A stock selling at 100 times earnings is far more vulnerable to a drop than one with a P/E of 12.

Investors searching for hints about the market's future also rely on a P/E statistic: the composite ratio of the 30 blue-chip stocks in the Dow Jones industrial average. Since the 1930s this figure has gone below 10 only during severe bear markets, and above 20 only in overexuberant bull markets. Its post-Depression peak was 24.2 in September 1961, shortly before a disastrous market break. It declined from 18 or 19 for several years in the early and mid-1960s to 15.7 a year ago and has increased only to 16.7 now. This is on the low side for a period of strong economic expansion like the present, suggesting that there is ample room for stock prices to go up.

*Or at least for the stock of every company making a profit in the past year. No P/E ratio is computed for companies that are losing money.

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