News reports probably should not be providing investment advice, but they certainly can, and should, provide a bit of analysis of stock prices. Like many people, I was stunned to hear that PetroChina, China’s state oil company, has an implicit market valuation of $1 trillion, more than one-third of the country’s exchange rate GDP. (That is an apples to apples comparison, the value of the company is expressed in dollars at the official exchange rate.) Does this price make sense? Without any special expertise in either the oil market or the specific prospects of PetroChina, it is possible to get a quick assessment with some simple arithmetic. According to published data, PetroChina’s earnings last year were $18.2 billion giving the stock a PE ratio of slightly more than 50 to 1. Let’s say that over the long-term, a PE ratio of 20 to 1 will be the norm for the oil company, allowing for a sustainable real return of 5 percent. Let’s say that it gets to this ratio after ten years in which its profits grow in real terms by 20 percent a year. Let’s also assume that investors would expect a 10 percent real return for investing in such a risky stock. To complete the story, we’ll assume that it pays out 60 percent of its profits in dividends. What do PetroChina and the world like in this scenario? Well in 2017, the market valuation of the company will be $2.2 trillion (in 2007 dollars). Its after-tax profits will be $113 billion (also in 2007 dollars). This would be equal to 7 percent of all projected profits in the United States for 2017. At its peak, General Motors accounted for about 1 percent of all U.S. profits, so the stockholders in PetroChina are betting that it will grow seven times as large relative to the U.S. economy as General Motors was at its peak. Suppose we did the same exercise with Google, which currently has a PE ratio of almost 60 to 1. Assuming 20 percent annual profit growth and a 10 percent real return will not quite get us to a 20 to 1 PE by 2017, but close enough (20.9 to 1). In 2017, Google would have a stock valuation of $514 billion (in 2007 dollars) and its annual after-tax profits would be $24.7 billion, or 1.6 percent of all corporate profits. You can relax the assumptions in various ways (more rapid profit growth, a longer period to get to a sustainable PE, or a higher sustainable PE and therefore lower long-run average return), but none of these paths sound very realistic and/or make the picture sound even more dramatic in terms of profits relative to the size of the economy. So, do we think that Google will grow to be 1.6 times as large a share of the economy as GM ever was or that China’s state owned oil company will equal 7 GMs or do we think that these shareholders are throwing their money in the garbage?
--Dean Baker
