The Great (Valuation) Debate - Part III
Good Morning. After eight consecutive up days and green finishes seen in twelve of the last fourteen sessions, even the most ardent bulls will likely admit that a pause might be in order right about now. So, with Ben Bernanke ready to launch into in his semi-annual chat with Congress today and Thursday (btw, the Fed Chairman's written testimony to the House Financial Services Committee will be released at 8:30 am this morning), it appears that traders decided that a break in the joyride to the upside was indeed in order yesterday.
However, one down day (amounting to a measly 32 Dow points) does not a pullback make. So, with traders basically waiting to see if Gentle Ben is going to change his tune on Capitol Hill this week, I thought this would be a good time to finish up our look at the various valuation metrics.
What we've seen so far is that the different P/E ratios we've reviewed suggest that valuations are a smidge above fair value while the P/D ratios show that stocks are expensive relative to long-term trends and fairly valued when compared to the trends of the past 25 years. So today, we will round out the analysis by reviewing the Price-to-Book, Price-to-Cash Flow, and Price-to-Sales ratios, as well as a composite model that takes various measures into account. Let's begin...
Price-to-Book Value Ratio: Book Value is a measure of corporate net assets. The measure is also known as shareholder's equity and is defined as a company's total assets minus total liabilities. Book value can also be thought of as an estimate of what the company would be worth if it were liquidated. In this case, we're taking the book value of all the companies in the S&P 500.
When looking at the Price-to-Book Value ratio since the late 1970's it becomes clear that the ratio rose steadily from the beginning to the end of the secular bull market that occurred from 1982 through 1999. And as one might expect, the ratio then declined precipitously from 2000 through early 2009. Therefore, we can conclude that this indicator tends to rise and fall depending on investors' long-term view of the stock market.
Although the range of the indicator is very wide (the high for the P/B over the 35.5 years has been 5 and the low has been below 1.0) and my data only goes back to 1978, the average P/B over the period has been 2.38. Thus, the current reading of 2.50 would be considered a "fair" valuation - especially over the last 20 years or so.
Price-to-Cash Flow Ratio: By now, the "price" part of our ratio should be obvious. However, to be clear, the definition of cash flow for this calculation is as follows: cash flow is the sum of undistributed profits of non-financial corporations with inventory valuation and capital consumption adjustments and the consumption of fixed capital by nonfinancial corporations. Yea, that's a mouth full. And no, I'm not about to calculate this on my own.
But that's what the computers at Ned Davis Research are for. In looking at the P/CF chart from 1952, it is clear that the range of prices was fairly consistent from 1952 through 1974, from 1975 through 1997, and from 1998 forward. So once again, we will need to decide which "valuation era" we are going to use.
The most recent quarterly data that is available is from 3/31/13 and the current P/CF level is 14.1. Prior to 1997, the P/CF ratio had been above 12 only twice; once in 1961 and again in 1969. As such, the current reading of 14.1 would appear to be high.
However, since 1997, the average appears to be closer to 16. Therefore, the bulls will argue that stocks still have a fair amount of upside. Frankly, I can argue both sides here. So, as has been the case with many of our valuation indicators, you need to decide whether you are looking at the more recent era or the entirety of history.
Price-to-Sales Ratio: This indicator is a little different in that (a) we use the S&P Industrial Average and (b) 12-month sales totals are used in order to smooth things out.
The trend of valuation "eras" continues to apply to this indicator. The range was clearly defined from 1954 through the mid-70's. Then the range moved down dramatically from 1974 through 1990, and moved much higher from 1995 forward.
However, the message from this indicator is quite clear. In short, stocks are overvalued from a Price-to-Sales ratio. Although I could try to argue that the current reading is about average since 2000, this just isn't enough time for a valuation indicator to be effective. As such, we'll have to give this one to the bears.
Valuation Composite Model: Another way to play the valuation game is to build a model. For this particular model, price is compared to the 10-year averages of: earnings yield, dividend yield, book value yield, real earnings yield, real dividend yield, earnings to bond yield spreads, and dividend to bond yield spreads.
One way to utilize this model is as a buy/sell indicator. And from a big-picture perspective, the results aren't half bad as the model gave timely sell signals in front of the 1970's bear market, the 1980 decline, the 1987 crash, and the bear market of 2000. But to be fair, the model booted the 2008 credit crisis bear entirely. It has since rebounded a bit as the indicator gave a buy signal in mid-2010.
As a valuation indicator, the model's overall record hasn't been bad. When the model says stocks are undervalued, the S&P has gained at a rate of +12.8% per year since 1965. And when the model indicates that stocks are expensive, the S&P has lost an average of -4.2% per year.
What is the model saying now, you ask? Although I can argue that the low interest rate environment may be "messing" with the model a bit, the reading is fairly bullish. In other words, based on all kinds of relative yield indicators, stocks remain a bit undervalued.
To summarize... As I opined in the very beginning of this series, valuation, like beauty, lies in the eyes of the beholder. In fact, most investors tend to see what they want to see in these indicators. And the fact that the most recent readings of the valuation metrics have been so volatile forces investors to decide which "era" is more appropriate to consider.
My personal take is that if I'm being objective, and using the last 20-25 years as my guide, stocks are currently fairly valued on the vast majority of the indicators. However, if we are going to go back and use a much longer-term time frame as our basis, then it is easy to say that stocks remain overvalued. Yet, we must also note that the indices have remained overvalued for the vast majority of the last 13 years. Like I said, the valuation business is a tough one.
While this is the very definition of a gray area, it is my sincere hope that this analysis series has been helpful in at least some small way.
Publishing Note: I have commitments from Thursday through Monday and will publish morning commentaries as time permits. Regular "Daily State" reports will resume on Tuesday.
Turning to this morning... Traders are clearly focused on two things in the early going. First there are the earnings reports. And second there is Ben Bernanke's semi-annual testimony in front of the House Financial Services Committee. The key question is if the Fed Chairman will back away from the dovish stance he took last week. As such, all eyes will be on the written testimony and perhaps more importantly, the Q&A session. Stay tuned.
Positions in stocks mentioned: none
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