Investors typically use P/E ratios to assess stock Value. It's easy to do and the information is readily available. But P/E ratios can't begin to provide meaningful answers for a variety of reasons, which I discussed in my essay of 09/10/10. The most serious problem with using P/E ratios to assess stock Value is that they are not measured against an independent standard.

This problem can be alleviated by comparing P/E ratios to Earnings Growth Rates, thereby creating the famous P/E to Growth, PEG, ratio and the less famous, but mathematically correct, Growth to P/E ratio, G/PE. Even this improvement, however, does not give the best answers. History tells us that P/E ratios vary with interest and inflation rates. P/E ratios are high when interest and inflation rates are low and P/E ratios are low when interest and inflation rates are high. The reason for this may be explained by understanding that "Money goes where money grows." (See my essay of 09/03/10.)

Investors put their money where they think it will give them the greatest rate of return. If P/E ratios of stocks are low and Earnings Yields, EYs, are high, money will flow into stocks. If bond prices are low and Interest Yields, IYs, are high, money will flow into bonds. When investors are fearful, as they are now, they will demand that the potential return on stocks be substantially greater than that of bonds. They want to be compensated for the risks they perceive in stocks. The current EY level of stocks in the S&P 500 is 7.13% and the IY of long-term AAA Corporate Bonds is 3.45%. Investors are demanding a 107% higher yield on stocks than they are on bonds. The difference between EY and IY is called the Yield Premium, YP. Currently, EY - IY = 7.13 - 3.45 = 3.68%.

The relationship EY = IY + YP, lays the foundation for stock valuation.

Since EY = 100/(P/E) = 100*E/P, we can substitute for EY and obtain the equation 100*E/P = IY + YP. Solving for P, gives us P = 100*E/(IY + YP).
Replacing P, Price, with V for Value, gives us V = 100*E/(IY + YP).

You may have noted that this equation is exactly like Eq. (6), shown on pg. 16 of Stocks, Strategies & Common Sense except it includes YP, the Yield Premium. Let's see how it works with McDonalds and compare the answer to the one we get with Eq. (6).

When the stock = MCD, Date = 09/23/10, E = 4.83 and (IY+YP) = 7.13%,
the equation shown above gives us, V = 100*4.83/7.13 = $67.74 per share.

Using Eq. (6) when E = 4.83 and IY = 3.45%, gives us,
V = 100*4.83/3.45 = $140.00.

Of course, this result is 107% higher than the first one because Eq. (6) does not contain the Yield Premium, YP. MCD closed at $74.64 yesterday, and VectorVest showed a Value of $99.03. So which valuation method does the best job of informing you of MCD's true Value?

Well, MCD's current P/E of 15.45 tells me nothing. The PEG and GPE ratios both say MCD is overvalued, which I don't believe, and the valuation formula adjusted for YP gave the closest answer to MCD's current Price. It, too, says that MCD is undervalued, but not by much. So, I'll have to say it's not too bad of an answer. Eq. (6) at $140.00 is way off the mark. The Value of $99.03 given by VectorVest is 25 bucks higher than MCD's current Price, but it seems good to me considering the extremely low level of today's interest and inflation rates, MCD's growth rate and financial track record. I like it the best. Of course, I'm prejudiced, but I'll stick with what I know best. That's VectorVest...especially when it comes to Stock Valuation.

BOTTOM FISHING WITH SURE-FIRE WINNERS.
Here we go again...another bottom-fishing strategy. What are we doing this for? We're doing it because it's one of the surest ways to make consistent profits that we have discovered, and we want you to know about it. We want you to have a bottom-fishing epiphany. Yes, a bottom-fishing epiphany. It was a revelation to me that you could make so much money, so consistently by buying "S" rated stocks. But you've got to know how to do it. So visit the VectorVest University to see Mr. Dan Misch's eye-opening "Strategy of the Week" presentation, "Bottom Fishing with Sure-Fire Winners."

VectorVest 7 IntraDay is just a click away. Yes, you may receive the fabulous VectorVest 7 IntraDay software at no charge by simply clicking on the following link: https://www.vectorvest.com/VV7Upgrade Now you can enjoy creating a portfolio with the click of a mouse using QuickFolios. Make testing your ideas easy and intuitive using the new BackTester. Let VectorVest tell you the second a stock meets your stop criteria using Portfolio Automation. Enjoy it and Do It Now.

WHERE THE RUBBER HITS THE ROAD.
The most important relationship between the stock market and the bond market is that of Earnings Yield, EY, and Interest Yield, IY. This is the line of scrimmage of the financial markets and is critical to helping investors decide where to put their money.

Earnings Yield, EY, in percent, equals 100/(P/E) or 100*(E/P). Therefore, EY increases as a stock's P/E ratio goes down. It increases as earnings per share, E, rises and price per share, P, decreases. Stocks with high EY levels are deemed to be more desirable than those with low EY levels since a purchaser would be getting more earnings per dollar of investment. The same thing can be said for stocks with low P/E ratios.

Interest Yield, IY, in percent, equals 100*(IP/BP). Therefore, IY increases as a bond's interest payment, IP, rises and bond price, BP, decreases. As with stocks, bonds with high IY levels are deemed to be more desirable than those with low IY levels since a purchaser would be getting higher interest payments per dollar of investment. For some reason, hardly anyone speaks about a bond's BP/IP ratio, but bonds with low BP/IP ratios have higher yields and are, therefore, deemed to be more desirable.

(As a side note, the authors of the WSJ article, "The Great American Bond Bubble," cited in my essay of August 20, 2010, were seriously derided for comparing BP/IP ratios of 100 to 1, to the 100 to 1 P/E ratios of internet and tech stocks of the late 1990s, early 2000s.)

In summary, both EY and IY go up when prices go down and they go down when prices go up. EY is low when investors favor stocks, i.e., when stock prices are high, IY is low when investors favor bonds, i.e., when bond prices are high. As of yesterday's close, EY for the S&P 500 was 7.14% and the IY of AAA Corporate Bonds was 3.61%. This means that bond prices are high and investors strongly favor bonds. Why is that?

Have you ever heard of "the flight to safety?" Investors take their money out of stocks, pushing EY up, and put it into bonds, pulling IY down, when they think stocks are too risky. Investments in bonds are inherently safer than stocks because the issuer of the bond is obligated to pay interest during the holding period and to repay the principal at maturity. There are no such guarantees with stocks. So what's not to like about bonds?

Bonds are meant to preserve capital and do not offer the potential for extraordinary capital appreciation that stocks do. So the challenge is to decide whether the potential reward for owning stocks is worth the risk. Everyone knows this, but most investors go about making investment decisions in an emotional, haphazard way. They know nothing about EY and IY. All they know is that they're scared. Investors that do know about comparing EY to IY, know that it is a logical beginning of the investment decision making process. They know that EY tends to be higher than IY most of the time, and they call the difference between EY and IY "The Yield Premium."

Stocks are cheap when the Yield Premium is high and expensive when the Yield Premium is low. Yes, it has been negative. When the market peaked on March 10, 2000, the EY of the S&P 500 was 4.84% and the IY of AAA Corporate Bonds was 7.80%. The Yield Premium was -2.96%. Stock prices were too high. It was time to be scared, and I was. We were in cash and went short the following week.

Comparing EY and IY is vitally important to understanding how the stock market works, and it provides the basis upon which our stock valuation methodology is built. EY vs. IY...it's Where the Rubber Hits the Road.

BOTTOM FISHING FOR SUPERCHARGED PROFITS.
If you liked last week's "Strategy of the Week" presentation, you should like this week's even more. Visit the VectorVest University and see how Mr. Bryan Barnes applies his magic to "Bottom Fishing for Supercharged Profits."

Using P/E ratios is a lousy way to assess stock value. Yet, everybody does it. The demand for P/E ratios is so pervasive that even we include them in our database. But our P/E's are different from what you'll find in your newspaper.

One reason for the difference in P/E's is that we use 12-month forecasted earnings, not earnings which are based upon 12-month trailing performance. Everyone knows that the stock market is a forward looking beast. Investors bet on future, not the past. So why make a barely useful number less informative than it could be? Another difference is that VectorVest shows a P/E ratio for every stock. For a variety of reasons, including low, zero or negative earnings, you will not find P/E data for about 20% of the stocks listed in media.

But the main reason I believe P/E ratios are barely useful is that the assessment of P/E's is totally subjective. There is no independent standard for knowing whether a P/E ratio is too high or too low. Anybody can give you any number of reasons why they think a stock's P/E is too high or too low, and who's to argue with them?

Years ago, I learned that you could tell whether a stock was over or undervalued by dividing its P/E ratio by its earnings growth rate. The theory was that high P/E ratios could be justified by high earnings growth rates. So a stock was deemed to be overvalued when the (P/E)/Growth ratio was more than 1.00. This (P/E)/Growth ratio test was popularized by Mr. Peter Lynch, the great manager of the Fidelity Magellan Mutual Fund, and it became known as the PEG ratio. The idea of comparing a stock's P/E to its earnings growth rate made sense to me, so I was off to plotting earnings data on semi-log paper and calculating growth rates like you wouldn't believe. Still, some things bothered me.

The one thing that bothered me the most was that I couldn't find a mathematical derivation for the (P/E)/Growth Ratio test, and I looked everywhere I could. That was before Google, of course. My search of PEG Ratio on Google got 408,000 results in 0.29 seconds. Wikipedia says the PEG Ratio, "is only a rule of thumb and has no accepted underlying mathematical basis." This statement is not true. I know because I ultimately derived the PEG formula, except it came out as G/PE which we include in the VectorVest database. Actually, I prefer G/PE to PEG because all of the other key indicators in VectorVest are favorable when they are above 1.00.

As of today, I have never seen an independent derivation of the PEG or G/PE ratio. Years ago, we used to show this derivation in our Two-Day seminars and the most interesting thing about it is that it shows that the appropriate test ratio for valuation is 1.00 when, and only when, the AAA Corporate Bond Rate equals 10%. Test ratios below 1.00 are appropriate when the bond rate is below 10%. This phenomenon is explained in our Stock Analysis Reports.

Take, for example, the case of F5 Networks, FFIV. It closed Wednesday at $96.36 per share. VectorVest had it valued at $68.71 per share with an RV of 1.43, GRT of 28 %/Yr., P/E of 34.29 and G/PE of 0.82. Is it undervalued or overvalued? If you compared the Price of $96.36 to Value of $68.71, you'd say that it's definitely overvalued. If you're a P/E type of person, you'd have to admit that a P/E of 34.29 is pretty high, so the stock is probably overvalued. If you're a PEG lover, you'd say a PEG of 34.29/28 = 1.22 is greater than one, so the stock is overvalued. You might think a G/PE person, like me, would say the stock is overvalued because 28/34.29 = 0.82 is below 1.00. However, I know enough to consult the VectorVest Stock Analysis Report. Oh my goodness, it says FFIV may be considered to be undervalued because 0.82 is well above the operative G/PE test ratio of 0.13%.

OK, time out. Everything, except the Stock Analysis Report, says that this stock is overvalued. What's going on? Well, last week we said that stock value goes up when interest rates go down. Interest rates currently are at historic lows and the Stock Analysis Report is taking that into account. It's telling the truth. Stocks are cheap. Take a look at RV. At 1.43, it's saying that this stock is likely to outperform a comparable investment in AAA Corporate Bonds by 43% over the next three years.

Think about it. What kind of return will you get on a bond paying 3.6%? In three years you'll make a total return of 11.93%. Don't you think a stock growing at 28 %/Yr. and an RS of 1.44 can appreciate more than 11.93% in three years? Sure, I know FFIV is currently overvalued, but with its high growth rate and fine financial performance, RV says that it's a better investment than buying 3.6% bonds. Anybody who uses P/E or PEG ratios to value stocks without taking interest rates into account is Playing A Fool's Game.

BOTTOM FISHING WITH THE BEST.
If you're looking to make money virtually every time the market rallies from a dip, you've got to watch this week's "Strategy of the Week" presentation. Visit the VectorVest University and Mr. James Penna will show you how to do it by "Bottom Fishing with the Best."

On page 14 of my book, Stocks, Strategies & Common Sense, I said, "Money goes where money grows. Stock prices go up when corporate earnings go up, and go down when interest rates go up." Hmm, we've had a stellar earnings reporting season in April and another in July. The S&P 500 average EPS is now 55% higher than it was this time last year and interest rates have been hitting historic lows. So why is the SPX down 2.24% so far this year? Shouldn't stock prices have gone up?

The short answer is yes, but things have happened which have affected investors' psychology. Right now, investors are fearful. They don't know what's going to happen and fear is dominating their investment decisions. People know their money isn't going to grow much at 1-3% interest rates, but they're afraid of losing what they have.

The WSJ article, "The Great American Bond Bubble," which I cited in my 08/20/10 essay, stated that investors buying bonds with 1% interest yields are likely to experience the same sorry fate as those who bought "Dot Com" stocks with P/E's of 100 or more 10 years ago. It also suggests that investors bet on stocks, particularly high dividend paying stocks, instead of bonds.

This presents the classic investment decision: does one invest in stocks or bonds? How does one decide? It's a matter of one's state of mind. If one is greedy and looking for capital appreciation, he/she buys stocks. If one is fearful and looking for capital preservation, they buy bonds. I answer this question by comparing the Earnings Yield, EY, of stocks to the Interest Yield, IY, of bonds, i.e., EY vs. IY. As of Wednesday's close, the average EY of the stocks in the S&P 500 was 7.41%. The IY of AAA Corporate Bonds was 3.58% and that of 10-Year T-notes 2.58%. So the EY of stocks was 107% and 187% higher than those of AAA Corporate Bonds and 10-Year T-Notes, respectively. With stocks so undervalued, why would anyone want to buy bonds?

The level of fear is very high. I measure this level by dividing EY by IY and wrote about it in my essay of March 17, 2006, called A Fear Index. I show a 50-year chart of this index and speak about it in my presentations on "Stock Valuation and Stock Market Cycles" at Money Shows and other events. As for the reasons for this state of mind, I recommend the following two articles: "The Decline of the P/E Ratio," WSJ, pg. C1, August 20, 2010 and "Shellshocked Investors Quit the Market," USA TODAY, pg. B1, September 3, 2010.

Note that all of these articles were written very recently. Is now the time to recall Mr. Warren Buffett's famous words, "The time to be fearful is when everyone else is greedy, and the time to be greedy is when everyone else is fearful?" If Mr. Buffett is right, it's Time To Be Greedy.

THE FASTEST HORSES.
Wouldn't it be nice to simply read the Daily Views and know exactly when to bet on the Derby Winner with the fastest horses? Of course, we've been working on this goal since the Derby was released more than a year ago. So visit the VectorVest University to see how Mr. Jerry D'Ambrosio does it in this week's "Strategy of the Week" presentation, "The Fastest Horses."