Beware of Phrases Like “Cheapest in 20 Years”

This week’s Barron’s highlighted shares of entertainment giant Disney (DIS) as being the cheapest they have been in 20 years. I just wanted to remind people that arguments like this in general don’t really make much sense. This is not about Disney itself (it is not an overvalued stock) but rather the whole idea that bulls on certain stocks like to look at one particular period in the past, and assume that those conditions should apply today.

These days you hear people say that certain stocks or sectors (or the market for that matter) haven’t been this cheap since the early 1980’s, and thus conclude they should be aggressively bought. What they fail to mention is that the period from 1982 through 1999 was the greatest bull market the U.S. stock market has ever seen, and P/E ratios were in a historically high range during that time. Therefore, investors should not assume that those valuations were “normal” and therefore should and will always be applicable.

The Barron’s piece suggests that Disney’s current forward P/E of more than 14 (the current market multiple) is too low because the stock typically trades at a 30% premium to the market. Again, just because a stock traded at a 30% premium a long time ago, that multiple does not stay relevant forever. P/E ratios are largely based on future growth expectations. If Disney is going to grow earnings less robustly over the next two decades than it did over the last two, it stands to reason its P/E should be lower.

My point is not to bash Disney specifically (no meaningful opinion there), but to remind investors that current valuations are based on investor expectations of the future, not historical data. Surprisingly, many people still look at average P/E ratios from the past 10 or 20 years to determine where a stock should trade today, but I would caution you to pass on that type of valuation methodology.

Full Disclosure: No position in Disney at the time of writing

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2 Thoughts on “Beware of Phrases Like “Cheapest in 20 Years”

  1. Brl4n on March 1, 2008 at 10:06 AM said:

    Indeed. If someone on TV says this I immediately discredit almost everything they say. Other metrics should be used as P/E is almost meaningless when you really analyze a stock. Fundamentals are key. Technicals are reassuring.

  2. Anonymous on March 3, 2008 at 11:20 AM said:

    I disagree. Although it is true that future growth might not be as good to justify the average multiple from the past, you almost always have some degree of margin of safety when a company trading at 20 year low on P/E. It’s certainly a good indicator that it’s time to do some more analysis.

    Earnings are meaningless?! I’ve heard that argument before….

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