Will Congress Change Retirement Savings Rules?

Retirement plan proposals currently under consideration by Congress will increase profits for Wall Street firms by increasing the use of high-cost 401(k) plans. These proposals do not assist the people having the hardest time saving for retirement. This memo evaluates the pension changes under consideration by Congress and presents alternative proposals.


Introduction:

recent CNN article describes several bills before Congress designed to change rules governing retirement plans including the Secure Act 2.0, a bill that has been passed by the House, and several proposals drawn up in the Senate. This memo outlines these legislative proposals and evaluates their potential financial impacts.

Features of the House Secure Act 2.0 bill:

  • Requires automatic enrollment in 401(k) plans, sets an initial contribution rate at 3.0 percent of salary, and increases contribution rate by 1.0 percent per year of service,
  • Increases catch-up contributions for people aged 62-64 and invest catch-up contributions in Roth accounts.
  • Allows employer matching 401(k) contributions on student loan payments,
  • Increases initiation age for required minimum distributions (RMDs) from retirement plans,
  • Require employers cover part-time workers working at least 500 hours per year for two years,

Discussion of bills in the United States Senate: 

The CNN article discusses several Senate bills addressing pension issues, which could be coupled with the bill that has already passed the House.

  • A bill offered by Senator Cardin and Senator Portman differs from the Secure Act 2.0 bill by excluding the automatic enrollment provision and its tax treatment of catch-up contributions.
  • A bill under construction by Senator Murray and Senator Burr may include provisions for new emergency savings options and annuity purchases by workers.
  • The starter K-bill offered by Senator Carper and Senator Barrasso facilitates creation of low-cost retirement plans, for small businesses and startups.  Proposed plans would have a $6,000 annual contribution limit and would allow automatic enrollment.

Analysis:

Comment One:  The automatic enrollment provisions in Secure Act 2.0 could lead to suboptimal savings outcomes for some workers.  It could lead to workers placing funds in a high-cost 401 (k) rather than a low-cost IRA.   (High 401(k) fees can decimate retirement savings as discussed here.)  Workers with substantial debt may be better off foregoing retirement contributions and rapidly repaying loans as discussed here. Many workers need to prioritize contributions to health savings accounts over additional contributions to 401(k) plans as discussed here.   This article makes the case for investments in Series I bonds outside of a retirement account instead of conventional bonds inside a retirement account.

Automatic enrollment into suboptimal financial options is bad policy.  The Cardin-Portman bill without an automatic enrollment provision would be preferable to the House bill.   A compromise bill would limit automatic enrollment to the amount needed to maximize receipt of the employer match and automatically enroll workers at firms without an employer match into IRAs.

Comment Two: An empirical analysis of the finances of people choosing to currently make catch-up contributions could determine if an expansion of catch-up contributions helps people who need to catch up or people already ahead.  It is likely expanded catch-up contributions for people in the 62-64 age group will primarily assist people who have little or no debt and are already well prepared for retirement.  People with debt should retire debt rather than increase contributions to their 401(k) because one of the worse financial outcomes is to enter retirement with outstanding debt and all financial asset inside a 401(k) plan.  

Comment Three:  It seems unusual to require catch-up contributions near retirement be made in Roth rather than conventional accounts.  I generally favor the use of Roth accounts instead of conventional account, but Roth contributions are most effective for young workers in low marginal tax brackets, not older workers nearing retirement.

Comment Four:  The proposal to increase the age of mandatory RMDs will benefit wealthier households capable of living by consuming from assets outside their retirement plans.  Less wealthy households will disburse their retirement assets earlier in life out of necessity. Households that delay distributions from their retirement plan because of the change in RMD rules will have to increase distributions and could pay higher tax later in life.

Comment Five:  The Secure Act 2.0 provision allowing employer matching contributions for workers making student debt payments will have a limited impact on savings incentives for most student borrowers and is not the most effective way to assist student borrowers.  Many young adults with student debt work at firms that either do not offer 401(k) firms or offer a plan without an employer match.  Young student borrowers that switch jobs prior to the employer contribution vesting will lose the contribution.  A rule allowing employer matching contributions into an IRA and allowing matching contributions for student debt payments would assist more student borrowers than the student-debt provision in Secure Act 2.0.

Comment Six:  The goal of increasing retirement savings for part-time workers would be better achieved by automatic IRA contributions instead of expanded 401(K) eligibility and automatic 401(k) contributions.   It would also be useful to change IRA rules to allow employer contributions into an IRA.   The participation of part-time workers into 401(k) plans will increase 401(k) fees.   Workers that use IRAs are free to select a low-cost highly diversified fund.

Comment Seven:  The goal of increasing retirement saving for workers at small firms that do not have a 401(K) plan would be better achieved through automatic enrollment in IRAS than by the creation of streamlined 401(k) plans.  Workers could seek out a low-cost IRA and are less likely to close the IRA than the 401(k) when they move to a new position. Also, the streamlined 401(K) option created by the Carper/Barrasso bill could displace more comprehensive 401(k) plans both among new and existing firms.  

Comment Eight: Many people currently withdraw a substantial portion of their retirement funds prior to retirement.  Around 60 percent of young adults have borrowed from their 401(k) plan.  It is unclear how the Murray/Burr bill will facilitate savings for emergencies while increasing saving for retirement.  One way to address this tradeoff is to encourage a shift in retirement savings from conventional accounts to Roth accounts.  Roth accounts allow disbursements of contributions without penalty and tax prior to age 59 ½ while conventional accounts apply penalty and taxes to all early disbursements.

Current retirement plan rules allow the worker to disburse all funds at any age if she is willing to pay an additional tax and penalty.  My view is any expansion of the use of retirement funds for emergencies without penalty or tax should be combined with a rule change that requires a portion of funds contributed to the retirement plan remain allocated for use after age 59 ½. 

Comment Nine:  An alternative to the Murray/Burr proposal for the purchase of annuities in a retirement plan is a program, like Oregon Saves, that allows workers to contribute to the state pension fund.  The Oregon Saves program also obviates the need for creation of retirement plans by small businesses.

Concluding Remark:  Proposals altering the retirement savings system currently in Congress favor the use of high-fee 401(k) plans over low-fee IRAs. The primary beneficiary of these changes is Wall Street, not households experiencing the most difficult saving for retirement.

The comments presented here support the view that rules allowing employer contributions into IRAs and automatic enrollment into IRAs instead of 401(k) plans are superior to the enlarged role of 401(K) plan offered by current Congressional proposals.   

Authors Note:  David Bernstein recently published a 2024 Health Care Reform Proposal, which differs substantially from the ACA modifications favored by the Biden Administration and the Medicare for All proposal favored by the progressives.  The program outlined in this paper available on Kindle would bring the United States close to universal coverage and would substantially improve health and financial outcomes for people with low-cost health insurance policies.

Lessons from the fall of ARKK

ARK funds are in free fall. Is there a better way to invest in high-risk startups?

Introduction:  ARKK, the ARK innovation ETF had fallen 58 percent from its all-time high by late January 2022.    The fund is experiencing massive outflows.  

What could Cathie Woods have done differently? 

Is there a way to create a fund that targets the most innovative companies but takes on less risk and does not experience this type of massive decline in value when things turn south?

Analysis:  Two Problems with the ARKK Investment Approach:

There are two problems with the ARKK investment model that led to this debacle.

The first problem involves an incorrect perception of the extent of diversification of the ARKK fund.

The ARKK fund, despite having 153 holdings, is not highly diversified.  The ARKK holdings have similar characteristics.  The firms are young, innovative, and risky. 

When risk appetites fall, as they are currently these firms fall in tandem.   

A portfolio manager could have a reasonably diversified portfolio based on either 153 randomly selected firms or 153 firms selected from different sectors of the economy. Much less diversification is obtained from a 153 similarly situated firms.

(It is sort of analogous to a person applying to all IVY league schools thinking one acceptance is in the bag because of the law of large numbers. The number of applications is not determinative when all institutions have similar decision rules.)

The tech fund could increase diversification of its holdings by holding 20 percent to 40 percent of its assets in a market portfolio perhaps through a Vanguard S&P 500 fund like VOO.   Alternatively, the tech fund could consider putting 20 percent to 40 percent of its assets in more stable value stocks, live VOOV, a fund that is uncorrelated with the startup sector.

A fund investing in high-tech startups needs to hold substantial funds in the general market or better yet invest substantial funds in the market that is not high tech.  A fund that invests 50 percent in innovative firms and 50 percent in startups would be able to reallocate assets when tech prices are elevated and make additional purchases during market downturns.

This approach is similar to the approach used by FBALX, a fund that balances stocks and bonds to provide more stable income in one fund.  The FBALX fund did well during the 2008 market downturn.

An ETF with both a tech portfolio and a market or value portfolio creates a better risk-return tradeoff than a pure tech startup portfolio.   The professional portfolio manager would reallocate assets from the tech component to the value component when tech was high and purchase tech assets when prices crash.

The person managing a combined tech/value ETF would probably be picking tech stocks at bargain prices right now rather than dealing with panic-driven withdrawals.

The second problem Impacting the risk of ARKK involves the existence of some very large positions inside several companies and a general lack of transparency exhibited by most ETFs (not just ARKK) on overall risk.

It is not accidental that Michael Burry, famous for the Big Short, was the first investor to highlight potential problems with ARRK.   Michael Burry is famous for looking at the quality of investments inside an ETF. 

I quickly looked at some of ARKK holdings.  My analysis for this post was limited to 10 holding found on the third tab of a listing by ZACKS.  The 10 holdings I looked at were – Fate Theraputics, 10 X Genomics, Docusign, Robinhood, Pacific Bioscience, Pager Duty, Iridium Communications, Tusimple Holdings, Gingko Bioworks, and Twist Bioscience.

My quick analysis found many ARKK ventures were highly speculative and were in the red.

Furthermore, ARKK had extremely large positions in some firms.

  • None of the 10 funds had positive earnings; hence, the PE ratio is undefined for all 10 firms.
  • The ARK management group was the largest shareholder for 4 of the 10 firms, was the second largest shareholder in one firm, was the third largest shareholder in two firms, was the fifth largest shareholder in one firm and the seventh largest shareholder in another.

ARK is a relatively small fund manager compared to firms like Vanguard, Fidelity, Blackstone, and T Rowe Price. ARKK is a relatively small fund compared to other tach and small-firm growth funds offered by larger firms.

Withdrawals from ARKK leading to the sale of company stock could exacerbate downward pressure on stocks when ARKK had an oversized position.

The recent withdrawals from ARKK and other ARK funds could have and likely did result in additional selling and downward pressure on stocks where ARK had a large position.

In a rational market the fundamentals of the stock prices determine the value of the ETF.  My concern is that selling by a risky ETF could spill over and impact the price of certain stocks.

Concluding Remarks:   The ARK funds allow investors to get exposure to innovative firms without taking on single-stock risk.  However, the amount of diversification offered by ARKK is not as large as some investors believe. The high stakes held by ARK funds likely exacerbated selling and downward price of some tech firms and the innovative company sector. 

One additional lesson from this post is that just as one should not judge a book by its cover one should not judge a fund by its profile.

Financial Tip #7: Invest in Series I Savings Bonds whenever possible

Middle income households should purchase some Series I Bonds from the Treasury annually.

Tip #7: Series I Savings Bonds should be included in every investor’s portfolio.  This asset purchased directly from the U.S. Treasury without fees is an effective hedge against inflation and higher interest rates.

Characteristics and rules governing Series I bonds:   The Series I bond, an accrual bond issued by the U.S. Treasury tied to inflation, is described here.  

Key Features of Series I Bonds:

  • Backed by the full faith of the U.S. Treasury
  • Cannot be redeemed until one year after issue.
  • Redemptions prior to five years from issue date forfeiture of one quarter of interest.
  • The composite interest rate changes every six months,
  • The interest rate is based on two components – a fixed rate and the inflation rate.   
  • The composite rate is guaranteed to not fall below zero.
  • The interest is taxed when the bond is redeemed.
  • Bond matures and stops paying interest after 30 years.
  • The Treasury limits annual purchases of the bonds to $15,000 per person with a limit of $10,000 on electronic purchases and $5,000 on paper purchases.  The paper Series I bonds can only be purchased through refunds from the IRS.

Reasons for Purchasing Series I Bonds:

  • Series I Bonds, unlike traditional bonds and bond ETFs, do not fall in value.
  • In the current low-interest rate high valuation environment, traditional bonds and stock prices are almost certain to decline in value.  
  • A retired person with I-Bonds outside of a 401(k) plan can respond to a market downturn by using proceeds from the redemption of I-bonds to fund current consumption rather than disburse funds from a 401(k) plan, which could be temporarily down in value.
  • The Series I Bond is a riskless asset.  Investors with this asset can reduce holdings of traditional bonds and cash and increase investments in equities.

Difference Between Series I Bonds and TIPS:

Treasury Inflation Protection Securities (TIPS also allow investors to protect returns when inflation and interest rates rise.

Key differences between TIPS and a Series I bond as explained here:

  • The TIPS value can fall in an era of deflation.  The Series I bond never falls in value.
  • The tax on interest from TIPS is paid annually and not deferred to redemption
  • TIPS bonds can be sold without forfeiture of any interest at any time.  The redemption of a Series I bond is not allowed until after a year from the purchase date and sales prior to five years from the purchase date involve a forfeiture of a 3 months of interest.  
  • All TIPS can be counted as a liquid asset.   Only Series I older than 5 years from issue should be considered liquid.
  • Up to $5.0 million in TIPS can be purchased in a single auction.  The annual limit on the purchase of Series I Bonds is $15,000.

Thoughts on Series I interest rates:

  • The current fixed interest rate on a Series I Bond is 0 percent.  The current composite fixed + inflation component on bonds purchased prior to May 2022 is 7.12%.  A delay in the purchase of a Series I bond until the second half of the year could result in a permanently higher fixed rate.  However, investors would lose an annualized return of 7.12% accruing in May. 
  • Bonds purchased years ago in a high interest rate environment have a higher current composite rate because the fixed component is higher.  People are currently aware of I-Bonds because of the elevated inflation rate.  The purchase of I-bonds also makes sense when inflation is low and interest rates are high because the investor will obtain both a higher fixed rate and increases in interest when inflation returns.

Concluding Thoughts:  Investors should purchase a Series I bond every year.  Investors who maximize receipt of the employer matching contributions to a 401(k) plan can then divert additional investments to a Roth IRA or a Series I Bond.  People without a 401(k) plan that allows matching contributions should contribute to a Roth, invest Roth contributions in equities, and divert some funds to the purchase of Series I bonds.

Financial Tip #3: Maximize use of after-tax Roth IRAs

Tip number 3:  Most households use traditional retirement accounts instead of Roth accounts.  The Tax Policy Center reports around 23% of taxpayers have a traditional IRA compared to around 12% of taxpayers with a Roth IRA.  According to CNBC, in 2016 around 70 percent of firms offered a Roth 401(k), but only 18% of workers used the Roth 401(k) option.  

More people should choose a Roth retirement plan over a traditional one.  People should use Roth accounts in the following circumstances.

  • Workers at firms not offering a retirement plan with a marginal tax rate less than 25% should use a Roth IRA instead of a deductible IRA.
  • Workers at firms offering both a traditional and Roth 401(k) should choose the Roth 401(k) if their marginal tax rate is less than 25%.
  • Workers with marginal tax rates less than 25% at firms with 401(k) plans without employee matching contributions should select a Roth IRA or Roth 401(k) over a traditional 401(k) plan.
  • Workers who maximize receipt of employer matching contributions should place additional contributions in a Roth IRA.
  • Spouses of workers with family AGI below the contribution limit for Roth contributions should contribute to a Roth IRA, if eligible.

Comments:

  • Gains from 401(k) contributions are relatively small when employers don’t provide a matching contribution and a worker’s marginal tax rate is low.  
  • Workers with Roth accounts are less likely to withdraw and spend all funds prior to retirement than workers with traditional accounts because they can access the amount contributed without penalty or tax prior to age 59 ½. 
  • The tax saving from Roth disbursements in retirement are high both because disbursements after age 59 ½ are not taxed and the Roth disbursement does not increase the amount of Social Security subject to tax.
  • Workers at a firm that do not match employee contributions, around 49 percent of employers, should contribute to a Roth IRA instead of a 401(k) plan unless the worker has a high marginal tax rate.
  • One effective contribution strategy is to take full advantage of the employer match and contribute all additional funds to a Roth IRA. Two common 401(k) matching formulas are 50 percent of the dollar amount contributed by the employee up to 6.0 percent of the employee’s salary and 100 percent of contributions up to 3 percent of the employee’s salary. 
  • Most new employees at firms with a vesting requirement, a rule delaying full ownership of 401(k) matches, should contribute to a Roth IRA instead of a 401(k) plan.
  • Stay-home spouses of workers with income should choose a Roth IRA over a traditional one if they are eligible. In 2021, a single filer with MAGI less than $140,000 and a married joint return filer with MAGI less than $206,000 cannot contribute to a Roth IRA.  Workers with income above these contribution limits should contribute to a Roth IRA.  Other workers should use a backdoor IRA.

Readers should remember to open their Roth IRA early in life as explained in financial tip number one.

Financial Tip #1: Open and fund a Roth IRA early in your career

Tip #1: Open and fund a Roth IRA and invest funds in a low-cost ETF when you get your first job in high school or college.

  • People who open a Roth IRA early in life have a long investment horizon.   The longer investment horizon allows individuals to invest in equities and accumulate substantial wealth.
  • A person who invests $1,000 in a Roth at age 17 will have $25,729 at age 65 if the average rate of return was 7.0% per year.   The total wealth at age 65 would be $62,585 when rate of return is 9.0% per year.  This Nerd Wallet article suggests the average rate of return on stocks is around 10 percent per year.
  • Firms like Fidelity, Schwab and Vanguard offer exchange traded funds with low fees and no minimum balance. A fund like VOO from Vanguard which covers the entire S&P 500 at low cost could easily earn 7% over long investment horizons.
  • The wealth estimates presented above assume the person does not tap funds in the Roth IRA prior to age 65.   This is not always possible.   The owner of the Roth IRA is allowed to disburse the after-tax contribution without penalty or tax at any time.   The Roth contributions can be used without penalty or tax for emergencies or to repay debt. The investment returns from inside a Roth are subject to penalty and tax if disbursed prior to age 59 ½.
  • All funds disbursed from traditional 401(k) plans and deductible IRAs are subject to penalty or tax if disbursed prior to age 59 ½. A young person embarking on her first job with a lifetime of obligations ahead of her should select the Roth over the traditional retirement plan, especially if there is no employer match, which is generally the case on a first job.

Concluding Thoughts:  Many employers automatically enroll new employees in a traditional 401(k) plan even though the worker would do much better in a Roth IRA.  Too many workers contributing to a traditional 401(k) plan, disburse funds prior to retirement and incur penalty and tax.  My view, expressed here and in several future posts, is that the Roth IRA should become the default option.

Do Dividends Affect Firm Value?

The Impact of Dividend on Stock Prices — a Regression Analysis

 Question:   Do firms that pay dividends have a higher stock price than firms that don’t pay dividend after accounting for earnings per share and sales per share?

Motivation:   The issue of whether dividends impact the value of the firm is a central discussion for students of finance. (My Ph.D. dissertation was on this topic.)

Modigliani and Miller found that if capital markets are perfect dividend policy will not impact the value of the firm.  More recent work indicates that dividends can influence firm value when capital markets are imperfect and insiders have better information than outsiders.

Dividend payments are unlikely to increase share value for older firms or firms with fewer growth opportunities.  By contrast, high fliers like Amazon and Netflix do not pay dividends.

Dividends can be associated with either higher or lower share prices.   The results can differ across industries and across samples of firms.

The Data:   The analysis is based on a single cross section of 67 firms.  The data was collected in mid-September 2018 after the close of market on a weekend.  Roughly half of the firms are large-cap growth firms and the other half are large cap value firms.

The data used in the regression analysis is described in the table below.

Description of Data in Regression Model
Mean Std. Err.
earnings per share 6.43 1.04
sales per share 160.29 91.41
Positive dividend dummy 0.87 0.04
price of a share 196.51 41.51

 

The Regression Results:

 

 

Regression Results for Share Price Equation
  Coeff. t-stat
Earnings Per Share 10.5 2.36
Sales Per Share 0.2 3.63
Dividend Dummy -331.0 -4.27
_cons 385.6 4.92
R2 0.66
N 67.0

 

Discussion of Regression Results

All three variables – earnings, sales and dividend dummy – are significantly related to price per share.

The dividend coefficient is negative suggesting that dividend payments are associated with lower share prices.

Why are dividend payments reducing share value in this sample?

The sample includes some growth names – Facebook, Amazon, Google, Netflix – which do not pay dividends.   The sample also includes some more established firms – GE, IBM, Coke, Pepsi and Bank of America – which are not growing fast but do pay dividends.

In this sample, growth prospects appear to have a larger impact on stock price than the promise of dividends.

Traditionally, firm earnings has been considered the more important determinant of stock price.  However, the sales coefficient has a larger t-statistic than the earnings coefficient.

Caveats: 

The model is built with cross-sectional data.  Cross-sectional models often do not explain the change in stock prices over time.

The dividend variable could be an endogenous variable.  A second equation that predicts dividend behavior and the level of dividends could be added.

A larger model might include information on capital expenditures and share buybacks.

 

 

 

Are Dividend Payments Sustainable?

 

Contingency Tables of Dividend Yields vs Dividend Payout

Issue:  Contingency table of dividend yield versus dividend payout for 35 growth stocks and 35 value stocks are used to analyze the sustainability of dividend payouts.

Contingency tables for the two portfolios are presented below.

 

Contingency Table for Dividend Yields vs Payout Ratios –

 Growth Firms

Dividend Yield
Dividend Payout 0 >0  & <=2 >2 & <4 >=4 Total
0 9 0 0 0 9
<=50 0 13 1 0 14
>50 & <=90 0 2 5 0 7
>90 or <0 0 0 4 1 5
Total 9 15 10 1

35

 

Contingency Table for Dividend Yields vs Payouts –

Value Firms

Dividend Payout 0 >0  & <=2 >2 & <4 >=4 Total
0 1 0 0 0 1
<=50 0 5 5 2 12
>50 & <=90 0 2 5 0 7
>90 or <0 0 3 10 2 15
Total 1 10 20 4 35

Comments on the Construction of the Contingency Tables:

The columns of the table are based on the dividend yield defined as annual dividend payments as a percent of the current stock price. The dividend yield measures the generosity of a firm’s dividend.

The dividend yield categories are – yield = 0, yield > 0 &yield <2, yield >=2 and yield <4, and yield >=4.

The rows of the table are based on the dividend payout ratio defined as dividend as a percent of income.   The dividend payout ratio measures the ability of a firm to maintain dividends in the future.

A dividend paying firm with negative earnings (or an undefined dividend payout ratio) is not likely to be able to continue paying dividends.

The four dividend payout ratios considered here are payout =0, payout<=50, payout>50 & payout<=90 and payout >90 or payout<0.

Note I have placed firms with negative earning that are currently paying dividends and firms with dividend payout ratios greater than 90 in the same high dividend payout category.   This makes sense because firms with high dividend payout ratios and firms paying dividends even though they have negative earnings will have trouble sustaining dividend payments unless earnings grow.

Note also by definition of yield and payout all firms with dividend yield equal to 0 also have dividend payout equal to 0.

Observations about dividend payments and sustainability of payments for growth and value firms:

 Growth firms pay less in terms of dividends than value firms.   There are 9 of 35 growth firms with a 0% yield compared to 1 of 35 value firm that pays no dividends.

A substantial percent of value firms may not be able to sustain their current dividend level.   15 value firms have a dividend payout over 90 or under 0 compared to only 5 of 35 growth firms.

Concluding Remarks:    The tech sector and growth ETFs have led the market upwards over the past couple of years.   A lot of analysts believe that the market can continue upwards through a rotation to value stocks.

I don’t see this happening.   Over 40 percent of my sample of dividend paying value firms has a payout ratio over 90 or negative earnings.   Their current dividend yield while attractive may not be sustainable.

A previous analysis of PE ratios indicated that many analysts are understating the overvaluation of value firms by ignoring firms with undefined PE ratios.

https://financememos.com/2018/09/12/valuation-of-growth-and-value-stocks-with-pe-ratios/

 

Valuation of Growth and Value Stocks with PE Ratios

Question:   The chart below contains the frequency distribution for trailing and forward PE ratios for 33 growth firms and 31 value firms.  The data was collected from the top 35 positions from two ETFs – VUG Vanguard large cap growth and VTV Vanguard large cap Value funds. Two growth stocks and four value stocks were omitted from the analysis because of negative earnings, which leads to an undefined PE ratio.

What can we learn about the relative valuations of growth and value firms from this chart?  How did the omission of firms with negative earnings impact our conclusions?  How do conclusions based on trailing PE and forward PE ratios differ?  What are the economic implications of large differences between trailing and forward PE ratios?

The Data:

Trailing PE Ratios
Growth Stocks Value Stocks
Freq. Percent Freq. Percent
Under 15 5 15.15 6 19.35
15 to 25 10 30.3 11 35.48
Over 25 18 54.55 14 45.16
Total 33 100 31 100
<=75 28 84.85 25 80.65
>75 5 15.15 6 19.35
Total 33 100 31 100
Forward PE Ratios
Freq. Percent Freq. Percent
Growth Stocks Value Stocks
Under 15 5 15.15 25 80.65
15 to 25 19 57.58 6 19.35
Over 25 9 27.27 0 0
Total 33 100 31 100
<=75 31 93.94 31 100
>75 2 6.06 0 0
Total 33 100 31 100

Short Answer:  Analysts on television routinely discuss PE ratios when talking about the valuation of the market.   Their analysis does not specify how PE ratios are assigned to firms with negative earnings or whether these firms are omitted from the sample.   The analyst often fails to state whether his analysis is based on trailing or forward PE ratios. Many analysts routinely present statistics, which understate the extent stocks are overvalued.

Observations about Growth and Value Firm PE Ratios

54 percent of growth firms and 45 percent of value firms report a trailing PE ratio greater than 25.

27 percent of growth firms and 0 percent of value firms report a forward PE ratio greater than 25.

15 percent of growth firms and 19 percent of value firms report a PE ratio greater than 75.

6 percent of value firms and 0 percent of growth firms report a forward PE ratio greater than 75.

Discussion of Growth and Value PE Ratios

I have not reported mean PE ratios because of outliers.  The max PE ratio for value firms in our sample was 272 for growth firms and 2352 for value firms.

The exclusion of firms with negative PE ratios makes it very difficult to measure and compare valuations.   Many analysts top-code firms with large or negative PE ratios.  One way to deal with this issue is to look at the earnings to price ratio (the reciprocal of the PE ratio) or to use techniques mentioned in a previous blog.

https://financememos.com/2017/10/11/two-ways-to-calculate-a-portfolio-pe-ratio/

This analysis substantially understates the current overvaluation of value firms.  Why do I say that?

  • First, more value firms than growth firms have negative earnings and have been excluded from the sample. The excluded negative earnings firms are arguably more overvalued than firms with low positive earnings and a high PE ratio.
  • Second, as noted the PE outlier is larger for the large cap value sector than the large cap growth firms.

A valuation analysis based on PE ratios does not always result in a larger bias for value firms than growth firm.   A comparison of small cap growth to small cap value firms might find more growth firms with negative or astronomic PE ratios than presented here for the comparison of the two large-cap portfolios.

The lower forward portfolio PE ratios are the consequence of an optimistic assumption on earnings growth.   As shown in a previous post one estimate of projected earnings growth is 100*(PET/PEF)-1 where PET is trailing PE and PEF is forward PE.

http://www.dailymathproblem.com/2018/09/financial-ratio-math.html

Projected Growth Rate in Earnings from the Comparison of

Trailing and Forward PE Ratios

Growth Stocks Value Stocks
Min -45.1 -51.6
Max 1,615.9 16,146.5

The comparison of trailing and forward PE ratios implies substantial dispersion in projected earnings growth.

It is very easy for an optimistic analyst or an analyst who wants to sell stock to juice forward earnings and make valuations seem more reasonable than they are.

Concluding Remark:

PE ratios are often imprecise measures of firm valuation, especially when earnings are low.   Analysts are using forward earnings estimate to obtain a more optimistic picture of the overall market valuation.  But are these estimates valid or reasonable?

 

 

 

 

Are Tech Firms Overvalued

Question:  The chart below has information on the trailing PE ratio, the forward PE ratio, the PEG ratio and 2014 and 2017 gross income figures for 9 tech firms.

How do the trailing and forward PE ratios differ for these 9 firms?

What is the implied growth rate in earnings from the trailing PE ratios and the PEG ratio?  How do these implied earning growth rates compare to actual earing growth rates?

What is the implied growth rate in earnings based on the forward PE ratio and the PEG ratio? How do these implied earning growth rates compare to actual earing growth rates?

Financial Statistics for Nine Tech Firms
Trailing PE Forward PE PEG Gross Income December 2017 Gross Income December 2014
AAPL 20.35 16.56 1.46 88.2 70.5
AMZN 159.84 79.55 2.51 65.9 26.2
MSFT 52.8 22.91 2.07 72 60.5
FB 27.73 21.49 1.1 35.2 10.3
NFLX 169.65 85.72 2.19 4.03 1.75
GOOG 53.96 26.03 1.75 65.27 40.69
NVDA 40.83 35.11 2.17 5.82 2.6
EA 52.57 20.61 1.68 3.87 3.09
TXN 26.17 18.41 1.41 9.61 7.43

Analysis:

Below is information on the trailing and forward PE ratios for the 9 tech firms.

Comparing Trailing & Forward PE Ratios
Trailing PE Forward PE Diff.
AAPL 20.35 16.56 3.79
AMZN 159.84 79.55 80.29
MSFT 52.8 22.91 29.89
FB 27.73 21.49 6.24
NFLX 169.65 85.72 83.93
GOOG 53.96 26.03 27.93
NVDA 40.83 35.11 5.72
EA 52.57 20.61 31.96
TXN 26.17 18.41 7.76
Average 30.83
Paired t test 0.018

The trailing PE ratio is larger than the forward PE ratio for all 9 firms.

This occurs because analysts are optimistic that forward earnings will exceed past earnings.

The paired t-test indicates we should reject the null hypothesis that the mean difference between the trailing and forward PE ratio is zero.

Note:   The implied earnings growth forecast used in a PEG ratio can be obtained by dividing the PE ratio by the PEG ratio.   The definition of a PEG Ratio is PE/G.   This means PE/PEG or PE/(PE/G) is equal to G.

The actual annual growth rate of earnings between 2014 and 2017 is ((E17/E15)(1/3) -1.

Below is the comparison of implied growth rates from reported trailing PE and PEG ratios to actual earnings growth rates.

Implied vs. Actual Growth Rates
Trailing PE Ratio PEG

Ratio

Implied Growth Rate Actual Average Annual Rate of Growth in Gross Profits 2014 to 2017
AAPL 20.35 1.46 13.9% 7.8%
AMZN 159.84 2.51 63.7% 36.0%
MSFT 52.8 2.07 25.5% 6.0%
FB 27.73 1.1 25.2% 50.6%
NFLX 169.65 2.19 77.5% 32.1%
GOOG 53.96 1.75 30.8% 17.1%
NVDA 40.83 2.17 18.8% 30.8%
EA 52.57 1.68 31.3% 7.8%
TXN 26.17 1.41 18.6% 9.0%

Implied growth rate based on trailing PE ratios.

For 8 of the 9 companies the implied growth rate from trailing PE ratio and reported PEG is larger than the actual growth rate in gross earnings.

Only NVDA had an implied growth rate lower than its actual growth rate.

Below is the comparison of the implied growth rates from reported forward PE ratios and PEG ratios to actual earnings growth rates

Implied vs Actual Growth Rates
Forward PE PEG Implied Growth Rate Actual Average Annual Rate of Growth in Gross Profits 2014 to 2017
AAPL 16.56 1.46 11.3% 7.8%
AMZN 79.55 2.51 31.7% 36.0%
MSFT 22.91 2.07 11.1% 6.0%
FB 21.49 1.1 19.5% 50.6%
NFLX 85.72 2.19 39.1% 32.1%
GOOG 26.03 1.75 14.9% 17.1%
NVDIA 35.11 2.17 16.2% 30.8%
EA 20.61 1.68 12.3% 7.8%
TSN 18.41 1.41 13.1% 9.0%

Implied Growth Rate based on forward PE ratios

For 5 of the 9 firms the implied growth rate based on forward PE ratio is larger than the actual growth rate.

The other 4 firms have higher actual growth rates than implied growth rates

Discussion:

 Are these tech stocks overvalued?

My view is there is a lot of unjustified optimism about these stocks.

Many of these firms had high actual growth rates 2014 to 2017.   This actual growth rate may be unsustainable.

Many of the implied growth rates calculated here are even higher than current unsustainable growth rates.

Perhaps analysts are using the growth rate of net taxes in their PEG estimates but tax cuts result in a one-time shift in earnings growth.  Soon the tax cut will define net earnings in the bae year of the earnings growth calculation.   This should decrease growth rates and cause the PEG ratio to rise.

Impact of Gender on Annuity Payments

Impact of Gender on Annuity Payments

 Introduction Females have longer life expectancy than males in virtually all countries.   Gender related differences in life expectancy make it more likely that females will out-live their retirement resources than will males. Females, because of their longer life expectancy, might choose to purchase a longer-term annuity.

Question:   A 75-year old person has $100,000 to spend on an annuity., which makes monthly payments for a fixed period.  She or he wants to reduce the probability of outliving the annuity to below 10 percent.

What annuity term would accomplish this goal for a male and for a female?

How does the longer life expectancy of the female affect the size of the monthly annuity payment?

Data Source: This analysis is based on the United States Life Tables, 2008 published on September 24, 2012 by the National Center for Health Statistics of the Centers for Disease Control and Prevention

http://www.cdc.gov/nchs/data/nvsr/nvsr61/nvsr61_03.pdf

Table Two of the report has life statistics for males and Table Three of the report has life statistics for females.   Both tables can be downloaded directly into an EXCEL Spreadsheet.The data in the Table below is from the CDC life tables. 

 

Age Total number of females alive at age x Proportion of 75-year-old females who survive to age X Total number of Males Alive at age X Proportion of 75-year Males surviving until age X
75 73,974 61,980
76 71,973 97.3% 59,531 96.0%
77 69,831 94.4% 56,962 91.9%
78 67,539 91.3% 54,268 87.6%
79 65,080 88.0% 51,437 83.0%
80 62,448 84.4% 48,469 78.2%
81 59,647 80.6% 45,390 73.2%
82 56,688 76.6% 42,227 68.1%
83 53,563 72.4% 38,994 62.9%
84 50,253 67.9% 35,694 57.6%
85 46,782 63.2% 32,360 52.2%
86 43,166 58.4% 28,996 46.8%
87 39,414 53.3% 25,650 41.4%
88 35,567 48.1% 22,372 36.1%
89 31,677 42.8% 19,213 31.0%
90 27,805 37.6% 16,223 26.2%
91 24,017 32.5% 13,448 21.7%
92 20,380 27.6% 10,928 17.6%
93 16,962 22.9% 8,691 14.0%
94 13,821 18.7% 6,754 10.9%
95 11,006 14.9% 5,122 8.3%
96 8,549 11.6% 3,783 6.1%
97 6,467 8.7% 2,719 4.4%
98 4,754 6.4% 1,898 3.1%
99 3,392 4.6% 1,286 2.1%
100 2,345 3.2% 844 1.4%

Analysis:

 Calculation the Annuity Term:

Based on this cohort of 100,000 females, 73,974 females have survived to page 75.   Around 90% of these females are still alive until somewhere between age 95 and 96.

In a cohort of 100,000 men 61,980 are still alive at age 75 and the 90% survival mark for these 75-year olds is reached somewhere between age 94 and 95.

Let’s interpolate to get an exact number of months for our annuity formula.

For females we get 96-75 (21) years plus (11.6-10)/(11.6-8.7) x 12 or (7) months.  The 75-year old female must buy an annuity of 259 months  to reduce the probability that she will outlive the annuity to 10 percent.

For males we get 94-75 (19) years plus (10.9-10)/(10.9-8.3) x 12 or 5 months (I am rounding up to fulfill the contract.)   The 75-year old male must buy an annuity of 233 months to reduce the probability that he will outlive the annuity to 10 percent.

Calculating the Impact on Annity Payments:

So now we calculate the annuity payments for the female and the male with the PMT function.   The only input that differs is the duration of the contract – 259 months for females and 233 months for males.

The annuity payment calculations were obtained from the PMT function in Excel.

 

Female Male
Rate 0% 0 0
Rate 3% 0.03 0.03
Rate 6% 0.06 0.06
NPER 259 233
PV $100,000 $100,000
Type 1 1 DIFFERENCE % DIFFERENCE WITH FEMALE AS BASE
PMT rate=0 $386.10 $429.18 ($43.08) -11.2%
PMT rate =3% $524.96 $566.77 ($41.81) -8.0%
PMT rate=6% $689.45 $727.62 ($38.17) -5.5%

 

Conclusions:   Females must buy a longer-term annuity to obtain the same reduction in longevity risk as a male.   This reduces their monthly annuity payment.

This annuity calculator on the web confirms that females receive lower annuity payments and or pay higher prices for a comparable annuity.  I am not familiar with the specific formulas used by this calculator or the product that it pertains to.   My sole interest here is to provide some insight on how gender determines longevity risk.

http://www.annuityfyi.com/immediate-annuities/