"I'll meet you anytime you want...at our Italian restaurant."
"Scenes from an Italian Restaurant" as performed by Billy Joel
Ever wanted to own a small, intimate restaurant, dine and mingle with your guests, and make it a way of life? It's never been my dream, but many folks love this idea.
Say you've found a place you like with lots of charm and plenty of potential. Thankfully, the current owner is tired of the daily grind and wants to sell and retire. Right now, you can probably purchase it on the cheap.
What price should you pay for the business?
Are you basing your purchase price on a multiple of this year’s terrible earnings? Probably not. The restaurant was operating on a half-open, half-closed basis this year due to Covid, so it might not make any money at all until next year. If you didn’t expect the earnings to rebound, you probably wouldn’t be buying the restaurant.
Instead, you’re probably looking at what the restaurant made in "normal" times before Covid, and assuming that the future will eventually be profitable. In other words, you’re "looking through" this year’s poor performance and anticipating a recovery in profits.
This is how we should view stock valuations today. Market pundits complain that stock valuations are historically high amidst an economic crisis and that the only direction for stocks is down. But to look at current multiples of earnings in the stock market today and not look through to future years misses the larger picture.
This doesn’t mean that P/E ratios or other valuation metrics are irrelevant. But one particularly bad hurricane season isn’t a reason to sell your house in Florida and move to Michigan. Same goes for your stock holdings.
In fact, P/E ratios actually have a tendency to rise during earnings recessions, which can make stocks look expensive when they’re actually cheap. Let me explain.
Earnings have basically been decimated, but many stocks are hanging strong, so this means that people are paying really high multiples for stocks. P/E multiples can expand during sharp earnings declines because the prices of the stocks often don't fall as fast as the earnings do, which has been the case these last few months.
But rather than thinking that their stock holdings are overvalued, based on a snapshot-in-time valuation metric, most long term stockholders of a company will write this year’s poor earnings off. They'll look forward to better times next year when the company returns to form. If those normalized earnings come to fruition, we’re back to a more reasonable P/E ratio. At the end of the day, the way a stock price goes up is if the P/E multiple expands, the earnings grow, or some combination of the two occurs.
In the short term, the multiple expansion or contraction is what drives the market. In the long term, earnings growth or decline drive stock prices. Earnings will likely revert to normal for many companies in the near future. Will you be ready?
Margaret R. McDowell, ChFC®, AIF®, author of the syndicated economic column "Arbor Outlook," is the founder of Arbor Wealth Management, LLC, (850.608.6121 – www.arborwealth.net), a fiduciary, "fee-only" registered investment advisory firm located near Destin, FL. This column should not be considered personalized investment advice and provides no assurance that any specific strategy or investment will be suitable or profitable for an investor.