We have carved out some time in between World Cup group stage matches this month to bring you part two in our Price is Right series  how to value stocks. Those of you wanting a refresher on the time value of money and bond valuation before we move on can find yourselves suitably refreshed here. Facetiously, stocks are worth what someone is willing to pay for them. Unlike bonds, there is no intrinsic starting point for valuing stocks. With bonds, you get your money back at maturity (hopefully), so it’s fairly straightforward to use that as an anchoring point and work backwards to a reasonable valuation. Stocks, on the other hand, have neither a maturity date nor an expected future price, which makes them more or less impossible to actually value. Not really kidding about that. There are textbooks upon textbooks upon college courses upon certifications all trying to impart some standardization to stock valuations. If you want to make the big bucks on Wall Street, you go work for an investment bank and spend all your time trying to figure out how much companies are worth. But saying “whatever, it’s all made up anyway” two paragraphs into a note isn’t particularly satisfying. So let’s take a look at common methods of valuation, and then we’ll see if we can learn anything about what those methods have to say about current stock market valuations. Cash Flow
You can try to force a time value of money (aka bond valuation) framework on to stocks. Most stocks pay some kind of dividend, so theoretically the current price of the stock should be the sum of all future dividend payments out to infinity discounted back to present value at the required rate of return minus the growth rate of the dividend. Pros: All you need to figure out a stock’s valuation is the current dividend (easy to look up), the growth rate of that dividend (easy enough to calculate), and your rate of return (make a number up that’s greater than the dividend growth rate). Cons: You’re assuming a constant rate of growth OUT TO INFINITY. If the growth rate changes at any point between now and forever, oops. Chances are you're not going to live to infinity, so your time horizons don't match up at all (in fact, you could say they are quite literally infinitely far apart). It's likely that even in the last five years dividend growth hasn’t been at a constant rate, so your assumption for g is flawed to begin with. Also, r is pretty much a made up number. And, if your company doesn’t pay a dividend (hello, Amazon), it’s worth exactly zero based on this model. Good luck with that. There are subtle variations to this model that look at various other cash flow metrics (think of something like revenue generated) instead of dividends and account for differing growth rates yearoveryear (Excel tables help), but you’re still making assumptions on growth out to forever, and you’re still excluding companies with negative cash flow (Netflix, Tesla). Price Ratio Analysis The other family of valuation methods looks at ratios of the stock price to some fundamental metric. Earnings are the most common (giving the ubiquitous P/E ratios), but you can use pretty much anything: revenue, book value, sales, free cash flow, whatever you want. We’ll stick with earnings and work through an example. Say the stock price of Company A is $20, and they had earnings of $1.25 per share last year. The P/E ratio for Company A is ($20/$1.25) = 16. Done. Of course, there are lots of permutations to this as well, depending on whether you’re looking at last year’s numbers, next year’s numbers, or a smoothed average of the last 10 years’ numbers. Pros: Easy. Not a lot of math involved, and no assumptions needed (unless you’re using next year’s earnings forecast, but even in that case, a oneyearout forecast isn’t much of an assumption compared to, you know, forever). Cons: The ratio in and of itself is meaningless. You are accepting the price of the stock as given rather than calculating what it should be, so the ratio only has value in a comparative sense. Is 16 a good number for Company A? Who knows. How does that compare to other companies similar to Company A? How does that compare to what its ratio has been historically? There’s a context that needs to be built around the ratio, and how that context is constructed determines its usefulness. The Price is...Right? All the different valuation models have the same question at their core  but that question is not what should the price of this stock be. Rather, it is some form of am I getting a good deal; is this stock more likely to go up or go down in the future. In the shortterm the market is a guessing game. Longer term, however, there are patterns that emerge  high starting valuations tend to lead to lower market returns, whereas low starting valuations tend to lead to higher market returns. Sounds selfexplanatory, right? Look up a chart of market returns vs P/E ratios. On a oneyear time horizon it's pretty much a shotgun blast. If you look at 15year returns vs. starting P/E ratio, however, there is a distinct pattern, even across different world stock markets. Mentally estimating zscores from pictures is tricky, but a P/E of 27 or so (where we are currently) puts us in the highest 8590% of P/E ratios in the market’s history. Go back and see what kind of 15year returns have historically been associated with a 27 P/E. Let's call it 4% or thereabouts? Well okay, there’s the pricing ratio method. What about the cash flow method? The S&P 500, on the whole, pays a dividend of $50 per index unit right now. Let’s assume that will grow at the longterm economic growth rate (g) of 3% (hahaha yeah right, but whatever, we’ll use it). And let’s also assume that the compound rate of return (r) is the longterm market average of 10%. Plug those numbers into the formula from the cash flow section and you get a price on the S&P 500 of 735. For reference, the actual price of the S&P 500 is about 2,700. Yes, that is 72% lower than current levels. We can rework that equation given a price of 2,700 to solve for the expected rate of return, r. Doing this gives an r of about 4.9% from current levels. Would you look at that, both methods pretty much agree. At current levels, you should expect just shy of 5% returns in the S&P 500 if you put your money in and close your eyes. For at least 15 years and possibly out to infinity. (Are you listening, pension funds? 5%!). Which, by itself, is not the worst: at 5%, your money will double every 14 years or so and you don’t have to do a single thing. But in context, the way those 5% compound returns will come about is not a straight line but more likely a couple years of negative returns followed by a recovery with greater than 5% returns. That’s the framework we are managing your investments within, and the main reason why we tend to err on the conservative side of things in the current environment. We fully expect P/E ratios to come down in the future and prospective market returns, r, to significantly improve. For that to happen though, prices have to come way down. Perhaps not 72% down, but even another Februaryesque move doesn’t do much to make valuations look super attractive from a historical standpoint. For those of you who are clients, you’ll see a Q2 statement coming up that is the most conservative we have been since opening our doors  we have reduced stock positions within portfolios by more than 20%, primarily in the international and emerging markets, and are poised to take even more risk off the table. Does this mean markets are about to drop? Not necessarily. Go back to those scatterplots and recall that 12month market returns are basically a dart toss….from someone who can’t play darts. But within the broader framework, we think it’s more likely markets are down 20% than up 20%, and our first priority right now is to mitigate that risk rather than stretch for potential return. If you’re not a client yet and the prospect of managing your own investments through a coming revaluation has begun to fill you with a slow, creeping dread, go ahead and give us a call. That’s what we’re here for. Comments are closed.

About the Blog:Here lives our collection of newsletters, articles, and some occasional guest posts by outside authors (where indicated) who have quoted us. If you're interested, feel free to browse through the archives here. Categories
All
