Molodovsky Effect and Your Stock Portfolio

July 31, 2012 - PRLog -- One of the most common measures of the value of a company’s stock is the Price Earnings (P/E) Ratio.  It is the per share price (P) of a company’s stock divided by its earnings per share (EPS). In their quest to buy low and sell high, value investors as opposed to speculators, seek to invest in companies with a low price earnings ratio. In his article, “A Theory of Price Earnings Ratios” in the Analyst Journal (1953), Nicholas Molodovsky observed that at the bottom of a business cycle Price Earnings Ratios tend to be high due to depressed earnings per share and conversely at the pinnacle of the business cycle they tend to be low due to elevated earnings per share. This research would seems to be contrary to the beliefs of many that growth stocks are associated with high P/E ratios and value stocks with low P/E ratios. However, if one takes into consideration the notion that the stock market is a discounting mechanism, then this makes sense.  The high P/E would be a harbinger of increased future earnings. As those earnings increase, the corresponding P/E would decrease. Similarly, a low P/E would increase as those earning decrease.
   Before trying to examine the validity of the Molodovsky Effect, solving the relationship between a stock’s price (P), its earnings per share (EPS) and its Price /Earnings Ratio (P/E) reveals that a stocks’ price (P) is equal to its Earnings per share (EPS) times its P/E.  Therefore, in a rational stock market in which valuations determine the price of a stock, there are only two ways in which the price of a stock should change. If its:
1.   Earnings increase, and/or
2.   Price Earnings Ratio increases
Conversely, a decrease in its earnings and/or its Price/Earnings Ratio should cause the price of its stock to decrease.
Like any other theory one can find examples that prove or disprove it. Let us go back to those thrilling days of yesteryear, when the banking crisis was starting to capture the attention of investors. At the end of 2007, Citigroup’s had a P/E of 40.9 which was significantly higher than the 13.1 in the previous year.  Its EPS were $42.0 in 2006 and $36.30 in 2007. In this case, Molodovsky was validated. In the case of American Electric Power the opposite results occurred. In 2004, it had a P/E of 12.0 which increased to 14.1 in 2005.  During those same years its EPS increased from $1.51 to $3.10.
The Molodovsky Effect can be proven or disproven after the fact, i.e., after a company’s results are in, but is not necessarily an effective predictor of future results. In order to be able to assess a company’s future prospects, one must answer three questions:
1.   How is the company strategically positioned?
2.   Does the company have the credibility to implement its strategy?
3.   Is the company’s stock attractively priced?
For further information on answering these three questions refer to A Common Sense Approach to Successful Investing, Utilizing the Power of Stratamentical Analysis by Marvin H. Doniger.