The stock market is a leading indicator; it generally falls before investors realize just how bad the economy is. It also recovers much before economic activity picks up.

Perversely, that means stocks often plummet during good economic times and rally before recessions come to an end.

Which is why down markets typically offer good opportunities to buy valuable shares at low prices. Here is the low-down on the best indicator of when share prices offer good buying value . . .

The relationship between price and value is clear, but is exceedingly difficult to measure. While price can be observed with certainty, no one can ever be sure what constitutes true value.

Although it may be impossible to objectively determine current value, in the light of hindsight it is clear that price does tend to revolve around it. Consequently, several indicators have been developed which purport to measure value and thereby provide a reference point for the relationship of price to value.

The logic is simple: if the market is undervalued, buy; if the market is overvalued, sell.

Dividend Yield

Long the most popular of valuation measures, the dividend yield is calculated by dividing the indicated dividend rate for the next twelve months by current price.

This figure can be calculated for any market average, or most meaningfully, for all stocks in aggregate. At times investor enthusiasm has been so great that the market has accepted a much lower dividend yield than normal.

When yields are very low, stock prices are, by definition, high, and frequently overvalued as well. The market, then, has nowhere else to go but down, so it is not surprising that, historically, a low market yield has usually been followed by declining prices.

Conversely, when the marketplace is rife with pessimism, investors demand a much higher than normal dividend yield to induce them to buy stocks.

Since an excessively high yield means that stock prices are abnormally low relative to dividends and are undervalued, the market frequently responds to such situations by climbing higher.

Table - I
U.S. Dividend Yields and Stock Prices (1 941 - 1975)

            Under 3.0 %                                -10.1  %                               0  %
           3.0% - 4.0  %                                + 2.0  %                              59  %
           4.0% - 6.0 %                              + 11.4  %                              72  %
           6.0% - 7.0 %                              + 15.0  %                              87  %
              Over 7.0 %                              + 37.8  %                            100  %

A simple test of the dividend yield as a forecaster of future US stock prices is presented in Table- I. Shown are the one year market returns which have ensued from various Dow Jones Industrial Average dividend yield intervals since 1941.

During the 35-year period the dividend yield was under 3% only 19 weeks (in mid-1959 and early 1966) and in every case the average ensuing one year market return was sharply negative.

The returns curve relatively smoothly up the dividend yield spectrum with exceptionally high returns following yields around 7%. Identical tests over other time frames reveal that the indicator is a relatively poor predictor of shorter-term price trends, but an excellent forecaster of long-term trends.

Indeed, the dividend yield is without peer in forecasting the market two to five years in advance.

Price Dividend Ratio

The normal way to calculate an effective annual dividend yield is to divide the latest twelve months' dividends, or the anticipated dividend rate for the next twelve months, by the current price, with the result expressed as a percent.

A few pseudo-sophisticated technicians invert the indicator and calculate it in precisely the opposite fashion, dividing price by dividend. The result is termed a Price/Dividend Ratio and, in effect, measures the number of dollars the market is willing to pay for one dollar of dividends.

In reality, the dividend yield and the Price/Dividend Ratio are, for all intents and purposes, identical; one is merely the reciprocal of the other. For example, a yield of 3% is comparable to a Price/ Dividend Ratio of 33.3, a 4% yield is comparable to a P/D Ratio of 25, a 5% yield is the mirror image of a P/D Ratio of 20, and so on.

Price Earnings Ratio

Most analysts view the relationship between dividends and stock prices as of merely passing interest. However, fundamentalists view the market's Price/ Earnings Ratio with a sense of urgency normally devoted only to higher subjects of ethics and morality.

The Price/Earnings Ratio is calculated by dividing current price by the latest 12 months' earnings per share. Dividend yields and P/E ratios are naturally highly correlated since they both relate a measure of company performance to the same variable . . . the price of the stock.

Dividends are, after all, paid out of earnings and, all other things equal, they will move in similar trends. Dividends do have one notable advantage, however: stability. Earnings fluctuate seasonally and to a great extent, even randomly.

Company managements seek to moderate these fluctuations by maintaining a dividend pay-out proportioned to the long run prospects of the company. 'Managing' earnings is easy -- any good accountant can do it. But distributing cold cash to stockholders requires a hard economic decision -- once paid out it is irretrievable.

It can also be argued, persuasively, that in the long run earnings mean nothing to stockholders unless they are ultimately paid out in dividends. A company can go on exclusively reinvesting earnings in future growth only so long.

At some point shareholders must receive tangible fruits of the earnings reinvestment if it is to be of any value to them.  Price/Earnings Ratios become distorted during severe economic contractions. Under normal conditions, a persistent decline in prices relative to earnings results in a falling Price/Earnings Ratio.

A low P/E, in turn, is generally bullish. The 1930s were an exception. The economic depression in the US was so deep then that when the market bottomed out in 1933, earnings had declined even more, drastically than stock prices and the Dow Jones Industrial Average's P/E was over 30.

A ratio of that magnitude would normally reveal extensive overvaluation of stocks and would be considered extremely bearish. In 1933, the high P/E Ratio merely reflected abnormally low earnings, not excessively high prices.

In fact, stock prices were extremely low and undervalued. (In contrast the D.J.I.A. dividend yield accurately reflected the market's undervaluation by rising to over 10%.)

Thus, while the Price/Earnings Ratio may be a fairly good yardstick of the relative prices of common stocks, it is generally inferior to the dividend yield as a market forecasting tool.

Book Value

Still another interesting measure of relative value is the relationship between common stock prices and company net worth.

Net worth, or book value per share, is calculated by adding up all of a company's assets (things owned), subtracting from it all of its liabilities (things owed), and dividing by the number of common shares outstanding.

The statistic is a theoretical measure of what a company is worth. If the price of a stock is far below its book value per share, the stock is considered undervalued and should be purchased.

Conversely, when the Price/Book Value Ratio is high, a stock may be significantly overvalued and should be sold (all other things being equal, of course).

The problem with this approach is that "net worth" may not represent what a company is in fact worth. After all, an asset is only worth what one can get out of it. If a company has a high asset value but never earns any money nor pays any dividends to its stockholders, it is worth very little to the stockholders.

Furthermore, book values are often extremely artificial reflecting only what company managements and accountants wish to put into them. Companies that are absolutely identical in all other respects can have drastically different balance sheets and, hence, dramatically different book values, simply as a result of accounting gimmickry.

What is true for individual companies is, by extension, also true for the market. The relationship between market indexes and aggregate book values has therefore always been an extremely erratic one, and predictions of future changes in the former from current levels of the latter is a risky undertaking. 

Q-Ratio

In an inflationary environment, book values are understated because the real values of assets rise. Economists call this actual value "replacement value." Stock price divided by replacement value yields the Q-Ratio.

While superior to indicators that merely use book value, it is almost impossible to calculate, and is of greater interest to theoreticians than to practicing investors.

Conclusion

Of the four fundamental indicators -- yield, P/E, book value, and Q-ratio -- the first is by far the best.

[Excerpt from Stock Market Logic by Norman G. Fosback. Published by Vision Books.]

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