Stock spruikers argue that equities are “undervalued”. But changes in the economic environment may make quaint measures such as price-earning (“PE”) ratios misleading. In a world of low growth, the dynamics of corporate earnings, which ultimately underlie stock prices, have become more complex.
Profit margins and cash flow improve, perversely, in a period of low growth. Initially, companies cut costs improving profitability. As revenues are stagnant, companies have no need to invest in expanding capacity or working capital, releasing cash flow.
Reduction in depreciation charges and the ability to use cash flow to reduce debt reduces interest expenses. In the present cycle, sharp decreases in interest rates, though not necessarily interest margins, have also improved profit margins.
These effects are short term. In effect, they misstate earnings.Woj’s Thoughts - After recently being called a permabear, a separate post on my equity outlook is certainly called for. In the meantime, consider the many ways (more at the link) in which Das shows companies are effectively misstating earnings. Although Das’ list is long, I think it is far from exhaustive. My general view is that companies are finding clever ways to increase current earnings at the expense of future capacity to drive revenues higher (i.e. borrowing to fund stock buybacks). If revenue growth continues at a pace well below previous cycles, earnings may peak much lower than most expect and P/Es of an earlier day may no longer be warranted.
S&P 500 Sales Per Share data by YCharts
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