Polemics & Exchanges

On P/E Ratios

David A. Hartman’s “Wall Street’s Turn” (Vital Signs, December 2002) accurately outlined several factors that drove the U.S. stock market to extreme valuations in the late 1990’s, and, as an equity portfolio manager, I found his insight to be both refreshing and a welcome respite from the utter nonsense of the mountebanks at the brokerage firms with whom I deal on a daily basis.  However, I would like to take issue with Mr. Hartman’s claim that the “most obvious misinformation that brokers propagated” was in switch-ing from valuing stocks on P/E ratios based on reported earnings to P/E ratios based on forecast earnings.  According to finance theory, the current price of a stock is the sum of its future discounted dividends.  (In the case of stocks that do not pay dividends, the theory supposes that every business enterprise will eventually run out of new investment opportunities and the excess cash thereby generated will be returned to the shareholders to invest.)  In order to calculate the expected dividend stream, analysts estimate a company’s future earnings and apply an appropriate dividend payout ratio.  Having made these projections using such financial statistics as earnings trends, asset values, and cash flow—all of which Mr. Hartman cited as relevant data—the...

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