Tuesday, June 5, 2007

The New PE Ratio

It can be heard with increasing frequency that your standard P/E (price to earnings) ratio should be replaced with a new PE (private equity) ratio. As the chart to your left shows, the combination of stock buybacks and PE deals is reducing supply of equities and, thereby, adding fuel to the bull market fire.

At around $2 trillion and counting, corporate cash and PE deal money (not to mention the $1.5 trillion in cash plus the 4 to 8 times leverage from the hedgies) are clearly having a profound impact on many areas of the investment landscape.

Investment Strategy Implications

Equity valuation 101 teaches us that private market values are always higher than public market values. Accordingly, investor expectations can be reset to a higher level if enough investors believe more deals are on the way. A price to deal ratio, if you will.

As with all new era talk, however, it is advisable to temper the enthusiasm as expectations based upon a continuation of the extraordinary stock buyback + PE driven deals at the current pace may not be sustainable resulting in PEs reverting back to P/Es.

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