JC Penney looks like the cheapest grab in the stock market right now according “CAPE,” a ratio used by serious value investors.
But looks can be deceiving.
Back in the 1930s when Ben Graham and David Dodd, the godfathers of value investing, wrote their famous book Security Analysis, they argued that to determine a company’s earnings power, you had to look at previous earnings beyond one year.
Then Yale economist Robert Schiller standardized that to 10 years, and the cyclically adjusted price-to-earnings (CAPE) ratio was born. It’s a pretty simple calculation — just the price of the stock over the average earnings of a company over the last 10 years.
Right now, JC Penney has the lowest one in the S&P 500 at 3.88, meaning it looks cheap, which should be a good thing — a buy signal.
But the way JC Penney looks right now is one of the biggest problems with CAPE that Wall Street value nerds have debated for years.
Why? Because a company’s past performance can’t always accurately predict its future performance.
See, if you divide JC Penney’s low stock price by the last 10 year’s average earnings — which will be relatively high, since JCP only started really taking a nose dive in the last year and some — you’re going to get a low number out of that P/E ratio.
It’s going to be a cheap number like 3.88.
But as we know, most of those last 10 years of earnings have very little to do with the dangerous cash crunch situation JC Penney is in right now. Even the most optimistic analysts expect earnings to be abysmal for quite a while if the company survives.
As JC Penney’s earnings stay below historic levels, the CAPE ratio will climb. It’s simple maths — the denominator (earnings) divides the numerator (price) by less and less resulting in a higher number.
But since it’s still the average of 10 years, that denominator, will fall slowly (perhaps more slowly than the stock price).
That means investors trying to get a sense of JC Penney’s earnings power using CAPE may find out too late that past earnings don’t always predict future earnings. By the time CAPE makes the stock look expensive, who knows where this whole story will be?
Don’t get caught in the value trap.
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