The New Math: Are Some High P/E Stocks `Bargains'?
Here is something investors haven't heard for a while: Coca-Cola stock is cheap.</br></br>Calling a megacapitalization blue chip trading at 38 times earnings cheap is heresy to many investors. But the fact that many strategists and even some conservative investors can now make that argument shows how the lowest interest rates in nearly two years are transforming the stock-valuation landscape.</br></br>Standard & Poor's 500-stock index trades at 23.54 times the past 12 months' earnings, not far from a record. The Dow Jones Industrial Average, which rose 28.35 to 7823.13 on Friday, is at 20.10 times earnings. Yet some strategists argue the combination of falling interest rates and still-robust earnings forecasts suggests stocks are a better value than they have been in a long time, including many high P/E blue chips like Coke.</br></br>Again, this may be a surprise to investors still jittery after the Oct. 27 stock plunge and the gyrations in global markets since then. And the same lower-rate scenario that supports the bullish argument also makes the stock market more vulnerable to higher rates than it has been in some time. But here is the bullish case:</br></br>Lower interest rates raise the present value of a company's future earnings. That is because an investor puts a higher price on future earnings if he or she will earn less in competing investments, like bonds. Furthermore, the effect accelerates the lower rates go. A drop in bond yields from 7% to 6% boosts valuations far more than the drop from 8% to 7%, a dynamic long understood by bond investors but not widely appreciated by stock investors.