My home in Maryland sits on a hill overlooking the 16th hole of a scenic golf course, complete with sand trap, water hazard and a little yellow pennant flapping invitingly in the summer breeze. So it makes sense that I would spend a lot of time on the links. As a matter of fact, I don't, but it makes sense that I would!

There are a lot of things in life that seem to make sense, but their reasonableness melts, even under the most casual examination. Here's an example that I have been coming across frequently in recent months: A tax lawyer who works down the hall from our offices stopped in the other day in search of a sympathetic ear. It seems that Ciena's latest earnings warning had taken a painful chunk out of his personal net worth. He was looking for validation of his idea that the stock "must be cheap" because it's 88% off its high.

I hope my facial expression showed compassion for his loss, but he sensed in me no resonance with his idea of "cheap," so he pressed his case. "What about JDS Uniphase? For crying out loud," he explained, "The stock is $8. This time last year, it was $128. When will you think it's cheap, at $3?" He was very animated, for a tax lawyer. A stock that was $128 selling for $8 has to be a bargain, right? It just makes sense. Or does it?

Just A Tool

Ordinary investors are not the only people who struggle with the question of whether a stock (or an asset class) is cheap or expensive. Investment professionals continue to wrestle with the issue of valuation. One of the oldest (and most "sensible") tools for gauging the value of a common stock is the ratio of its share price to the company's earnings per outstanding share, or the Price/Earnings (P/E) ratio.

My first full-time job was as a securities analyst trainee at Standard & Poor's. I remember how excited I was to discover and experiment with the P/E ratio concept. I was working on an electric-utility company in a growing part of the Southeast; its shares were selling for 18 times their current earnings per share. I noticed that some utilities in the slow-growth Northeast were trading at 12 times earnings and came to understand that all electric companies are not endowed equally when it comes to growth prospects. My mentor pointed out that growth prospects chiefly explained the difference in stocks' P/Es. Made sense, I thought.

Awhile later, I was doing research on some auto-parts companies. One in particular, A.O. Smith, was selling at 7 times earnings. I thought, "Wow! That's so cheap!" (I had in mind my electric utilities as a frame of reference.) So I bought 10 shares at $34 a share (remember, this was my first job, and I was earning $110 a week). I checked the price daily, watching it dribble down to a humiliating $25 a share before I threw in the towel. This turned out to be a valuable life lesson in the fact that not everything that looks cheap really is. I also surmised, once my ego recovered, that a P/E ratio does contain useful information, but it is just one of many tools for understanding the concept of value.

Pete's Diner

As professional investors, we take the lowly P/E ratio for granted. It is an everyday tool that helps us compare stocks or groups of stocks (such as sectors and indexes), and it puts present valuations in some sort of historical context. When we say, for example, that the S&P 500 is selling at 24 times peak-cycle earnings, versus a historical average P/E of 14, it means something to us. But many of our clients glaze over when we hold forth on the subject. It's very vague to them. So, a few years ago, I devised the following story to make it more understandable for people who don't "do" investments.

Imagine, I say, that it's a cool Saturday morning in October, two months before your official retirement date. You are sitting on a stool at Pete's Diner having your first cup of coffee and wondering to yourself what life is going to be like when you no longer have an office to go to, a payroll to meet or patients to see. Your mind drifts, and you start to think about all the times you brought the kids here for breakfast when they were growing up. And the late-night snacks with your neighbors after the movies. Gee, Pete's always had the best clam chowder. And people come for miles around for their famous crab cakes. This place is a real landmark.

Your reverie is interrupted by a cheery "Good morning" from Pete himself as he refills your cup. "Say, Doc," Pete rests both hands on the counter, "Have you heard that I'm going to retire this winter, just like you? Going to put the ole place up for sale after all these years." "Really?" you say. "Good for you, Pete. This will be a real nice business for somebody."

"Yep," says the owner with more than a little pride. "Earns $100,000 a year profit, year in and year out. It's not a lot of trouble, and you meet the nicest people." As Pete moves down the counter to wait on another customer, you start to wonder; "Maybe I could use a small business to keep me busy."

At this point, I usually interrupt the story and ask my audience or my client, "How much do you suppose this doctor would have to pay to buy Pete's Diner?" They don't usually answer right away, thinking my question is rhetorical. So I have to cajole a little bit, and finally I'll get timid answers like, "$100,000?" Or "$200,000?" To stimulate their offers, I suggest that there are likely to be other people interested in buying the diner. After all, it is a local legend, it's been well- maintained, and it's not the world's most complicated business. Besides, this is probably a recession-resistant business because people have to eat, right? So Pete won't have to accept just any offer. The highest "bid" I have ever gotten from telling this story is $1,000,000. More often the audience peaks out at $500,000.

That's only five times earnings, I tell them. Pete's Diner earns an annual profit of $100,000, and you're only willing to pay him $500,000? You're giving the diner a price-to-earnings or P/E ratio of five. Would anyone pay Pete $2.4 million? After several guffaws of disbelief, I say, "If this diner were the economy, as represented by the S&P 500 Index, it would go for $2,400,000, even though its profits are only $100,000 a year. That's what 24 times earnings means. That's an annual return on your investment of only 4.1%. You can make more than that on a 10-year municipal bond that's entirely tax free, with no risk to speak of.

Risk And Reward

Turning the P/E ratio upside down to express it as a return on investment is an eye-opener for a lot of people. And comparing it with the return on a possible alternative investment is practically an "Ah ha!" experience. I really enjoy seeing their lights go on.

This usually leads us into a brief comparison of a single business (Pete's Diner) with the whole American economy. We notice a couple things. A diner is more vulnerable than a big, diverse economy. The Diner Corp. might open a stainless steel retro beauty next door and empty half your booths. Or an uninsured "act of God" could wipe the place out. On the other hand, it is a lot easier to double a diner's traffic than it is to double a $10 trillion economy. So a diner's business has more risk but more opportunity as well.

Another big difference is that when you own a diner, you have to make the decisions (or you "get to" make the decisions, depending on your point of view.) But when you are a shareholder in a publicly owned enterprise, you are a passive, absentee, minority owner. (Marty Whitman of the Third Avenue Value Fund provides an illuminating treatment of this subject in his excellent book, "Value Investing: A Balanced Approach.") Passive investing means less work but less control. Also, if you don't like the way things are going in your portfolio of stocks, you can liquidate them on a moment's notice. It's a much bigger deal to find a buyer for your diner. The active business owner suffers a liquidity disadvantage.

So, should a diner have a higher or lower P/E than the economy or "the market"? The long and colorful history of transactions in public and private securities suggests that public companies are worth more, on average, than private ones. There are many reasons for this average premium: liquidity, access to expansion capital, professional management and so on. But we must always be careful when we rely on an "average"; the Chesapeake Bay is only three feet deep, on average, but to walk across it is to drown. If diners within 30 miles of Manhattan have been selling for 4 to 6 times earnings and you are thinking of paying 12 times earnings for Pete's place, you probably ought to have a clear idea of how you are going to double or triple the diner's annual earnings before it's time to sell.

Stock Market Analogy

In a similar way, if the long-term average P/E ratio for the market (let's use the S&P 500 just because it provides a long history of data) is 14, and we're going to invest in it at 24 times earnings, it's probably in our interest to ask what's so special about the opportunity today that makes us willing to pay much more than millions of others have been willing to pay in the past for a similar basket of businesses. There could be good reasons-earnings are temporarily depressed or the earnings will grow faster in the future than in the past-but we should be able to identify them.

There is one enormous difference between buying a controlling interest in a diner, on the one hand, and being a passive minority investor in stocks, on the other. You typically buy a diner because of the annual free cash flow it can generate by turning ground beef into meatloaf; you can take that cash flow home if you want. But you typically buy a public stock with an eye toward selling it later to someone else for more than you paid (this is especially true in this era of paltry cash dividends on public securities.) You're not all that interested in how the company's actual business works; you just want the stock price to go up.

The existence of a liquid market for shares is what allows stocks to take on a life of their own, separate from the underlying business realities that they signify. The fact that shares can easily be bought and sold is what allows the average P/E ratio to fluctuate to extremes, both high and low. The tide of demand for shares reflects the ebb and flow of investor optimism regarding future prices. Ultimately, there is still some relationship between the market value of a stock and the profit-generating ability of the business named on the certificate. But the relationship is not nearly as immediate as it is in the case of the diner.

So, is Ciena cheap? Or JDS Uniphase? I must tell my tax-lawyer neighbor the truth: "I have no idea." With respect to an individual company, almost anything can happen. Reported profits may be wiped out by restatements that make the whole enterprise look suspicious. Or a dramatic surge in demand for the products may be just around the corner. These kinds of uncertainties are the reason we diversify our portfolios.

But a free economy of 250 million consumers and worker bees acting in their own self-interest is apt to be much more predictable, at least over longer periods of time. Most advisors feel confident looking for 2.5% to 3.5% annual real growth punctuated by slumps and recoveries. Business profits as a percentage of sales tend to range between 3% and 6%. And we have a long history of "market" P/E ratios running from about 7 to 20. That's our frame of reference. Then along comes 1999-2000 with 6% profits and a P/E of 35. What do we do with that? Pete, how much did you say you wanted for your diner?

J. Michael Martin, JD, CFP, is president of Financial Advantage in Columbia, Md.