Statistics plays a very useful and constructive role in almost every walk of life. Statistics is all about analyzing a myriad of historical data to extract useful information and trends and use this information for making important decisions for the future. Though there is no guarantee that what has happened in the past will occur in the future as well; but there is an equally important case for believing that something which has withstood the test of time in a reasonably long period of time in the past will stand the same test in future as well. Besides, the historical data and information extracted from the same are the only thing that one has in hand while taking the decisions for the uncharted territory of the future. Therefore, it is not surprising that people rely on historical data and the information extracted from it to make the appropriate decision for the future.
Investment decisions are something very important for all of us. We need to save from our hard-earned money and invest the same to create a pool of resources to rely upon on our bad days. But, investment decisions are probably the most difficult. One has to choose a set of investment opportunities that optimizes between the risk and return, i.e., while return should be maximized, the risk should be minimized at the same time. One of the very important investment options is equity investing. This is best from return consideration, but at the same time, worst from risk consideration. Therefore, people need to pay the greatest attention with respect to decisions in equity investments. In this case, also, statistics provide great help.
The article “Those with Sense of History May Find It’s Time to Invest” by Alex Berenson is such an article in which the author has discussed, using relevant historical parameters, how this is the best time to invest. Inequity investing, there is one very important and popular parameter – P/E or price to earnings multiple. This is the ratio of the price of a share to the net earnings per share. What analysts do is that they keep tracking this parameter. Besides, analysts calculate P/E based on estimated forward earnings as well, and they compare it with historical values. The same analysis is done with the index as well. A high value of P/E implies optimism in the business outlook for that company; an extremely high value implies greed, and an extremely low value implies fear.
In this article, the author has relied mainly on this parameter while making a case for the current situation being the time to invest. The author has given an example of an index S&P which is currently trading at 13 times P/E. This valuation for the index is the lowest in the decade. The author has also given another example of a company Newell Rubbermaid which is trading at just eight times its one-year forward P/E. The author says people are valuing this company as if it is going out of business. That too, when this company’s business is not so prone to recession, yes, the demand for its products will come down, but so will the raw material cost (as crude is falling), and the company’s balance sheet is not at all leveraged (a measure of debt to equity ratio), so there is no rationale for the brutal hammering of its scrip. But the scrip is trading at a valuation which is the cheapest since 1990.
Thus based on the historical average of a very important parameter P/E, the author has made a case for the current crisis or the state of fear in this market as being a very good time to buy stocks and has substantiated his point with some relevant examples. This article is thus a good example of how historical averages of a relevant parameter can be used to make investment decisions.
Reference
Berenson A. “Those with Sense of History May Find It’s Time to Invest”. 2008.