Market Valuation Metrics: Where Do We Stand?

/Market Valuation Metrics: Where Do We Stand?

Market Valuation Metrics: Where Do We Stand?

By | 2017-08-18T17:00:59+00:00 March 18th, 2015|$SPY, $vlue, $voo|20 Comments
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(Last Updated On: August 18, 2017)

We recently examined a handful of metrics related to S&P 500 valuations.

  • P/E
  • P/B
  • TEV/EBITDA
  • TEV/FCF
  • TEV/GP

Details on these metrics can be found here.

Let’s look at the high level summary as of February 28, 2015 from 1/1990 to 2/2015:

PE_RATIO PB_RATIO TEV/EBITDA TEV/FCF TEV/GP
Current 18.49 2.85 11.57 23.08 6.57
Current Percentile 54% 65% 73% 25% 56%
Min 11.89 1.64 6.36 13.52 3.09
5% 13.88 1.94 7.40 15.36 3.85
25% 16.39 2.27 8.91 23.22 4.84
50% 18.09 2.69 10.38 34.07 6.14
75% 22.65 3.05 11.75 46.62 7.63
95% 27.82 4.67 13.49 61.14 8.45
Max 29.92 5.00 14.51 145.10 9.00

The metrics aren’t screaming “overvalued:” P/E, P/B, TEV/EBITDA, and TEV/GP are all in the 50-75 percentile; TEV/FCF is actually in the 2 to 25 percentile.

In fact, adjusted for the current interest rate environment (much lower than it was in the past), the argument that the market is extremely overvalued is arguably far-fetched.

Visual Valuations:

P/E

Price-to-Earnings

pe

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

 

P/B

Price-to-Book

pb

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

 

TEV/EBITDA

Total Enterprise Value-to-Earnings Before Interest Taxes Depreciation and Amortization

tev

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

 

TEV/FCF

Total Enterprise Value-to-Free Cash Flow

tevfcf

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

 

TEV/GP

Total Enterprise Value-to-Gross Profits

gp

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

 

Additional Thoughts

Our quick and dirty analysis suggests that the market isn’t extremely overvalued.

But this doesn’t seem to jibe with many reports coming out in the media. Why?

The answer has to do with a framing effect. Many “markets-are-crazy-expensive” stories look at the history of markets going back to <1900 (typically using the Shiller CAPE data). We just did our own version of this story a few weeks ago.  Sure enough, based on CAPE ratios, the market is in the 94th percentile–pretty high!

Nonetheless, the data for our metrics only go back to 1990–not 1890!

When current valuations are positioned against valuations over the past 25 years, things look “normal-ish.” Yet, when current valuations are positioned against valuations from pre-1990, they may appear “insane.”

Not sure what to make of this “framing” effect. On one hand, a longer history may give us more insight into valuations over time, on the other hand, market conditions 100+ years ago may be different than they are today.

How useful is it to compare valuations today, versus valuations that prevailed at other points in history? The dynamics associated with longer run regimes may be in place. For example, in the beginning of the 20th century, the U.S. market was a comparatively young emerging market economy, and it wasn’t obvious that it would emerge as the dominant economy for the next 100 years. In these early days, the U.S. market may have been priced more cheaply based on its embedded emerging market risk. For a more modern example, consider valuations on the BRIC and the PIGS versus the developed market countries? Emerging market countries often have more risk, so on average, their valuation metrics are much lower than those of developed market countries.

Also, 25 years is a decent length of time. Maybe this sample from the recent past better represents current conditions and risks associated with investing in U.S. markets today, versus the alternatives.

Again, when you are computing average valuations, if you include long stretches when U.S. markets were cheap for reasons unrelated to important aspects of modern world economies, you may get an average that is flawed in some ways. Then again, this sounds a bit like the “new valuation paradigm” thinking that prevailed during the dotcom boom when valuations went crazy.

Regardless, our analysis above will hopefully enhance the discussion around market valuations. The current discussion is very black and white–commentators are calling for an epic and inevitable crash, or they are calling for Dow 100,000. Hopefully, we open the debate and generate more nuanced views on market valuations. A good example of this type of sophisticated thinking is presented at http://www.philosophicaleconomics.com/. If you know others, please share.

 


  • The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Alpha Architect, its affiliates or its employees. Our full disclosures are available here. Definitions of common statistics used in our analysis are available here (towards the bottom).
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About the Author:

After serving as a Captain in the United States Marine Corps, Dr. Gray earned a PhD, and worked as a finance professor at Drexel University. Dr. Gray’s interest in bridging the research gap between academia and industry led him to found Alpha Architect, an asset management that delivers affordable active exposures for tax-sensitive investors. Dr. Gray has published four books and a number of academic articles. Wes is a regular contributor to multiple industry outlets, to include the following: Wall Street Journal, Forbes, ETF.com, and the CFA Institute. Dr. Gray earned an MBA and a PhD in finance from the University of Chicago and graduated magna cum laude with a BS from The Wharton School of the University of Pennsylvania.
  • drc

    hey wes

    thx for the post – good stuff. two quick reactions

    1) it might be more useful to estimate forward looking expected returns from these valuation levels rather than just comparing to historic “norms”. granted, the calculation of expected returns would probably imply some reversion to a “normal” multiple in which case you kind of are back at square one….

    2) you and others have shown that investing based on valuations at a macro level may not beat buy and hold even though intuitively it makes a lot of sense (i know there are arguments in the other direction as well). in some respects, it makes me wonder if the whole debate of “over”/”under” valuation is not a good use of time when thinking through asset allocation.

  • 1. true, but hard to get that data.
    2. Yep, pretty much. We have a series of posts coming out highlighting that valuation-based asset allocation techniques are shaky, at best.

  • bbarberayr

    Good article, but framing is always the hard part.

    The last 25 years have been a period of declining interest rates. Obviously this doesn’t continue into the future. One key consideration becomes “do valuation metrics which apply in a declining interest rate environment also apply in a rising interest rate environment”? It is logical to think that people will not be willing to pay as a high a metric if they believe they can lock in risk free returns at a higher rate in the future.

  • woof

    have you tested using the average of these metrics to time the market?

  • MrDodge

    Some interesting charts there. I’m not sure how useful the P/E metric is though – look at the enormous spike in early 2010! clearly the market wasn’t much more expensive than mid 2007, yes this metric says it was. What’s interesting about the Shiller PE is that it has very successfully predicted future 30 year returns. As you correctly state, this all really boils down to whether the last 25 years were really different to earlier periods. I suspect its all about interest rates.

  • We didn’t even mention interest rates…that makes the over/under valuation discussion even more complex. Main point is it is difficult to make statements like “God, this market is so overvalued I can’t even believe people would buy stocks.”
    Lot more complexity involved…

  • we’ve tested almost everything…we will have a trail of our research findings on this subject coming out over the next few months.

  • Nice insights.

    And yes, current valuations definitely predict future returns. Almost by construction, higher prices imply lower expected returns, on average, over long time periods.

    Interest rates play a huge role in asset prices–they serve as the reference point for pricing every other asset in the macro economy. As the old saying goes, equity earns risk-free + 4%. When 10-yr bonds are 6%, that implies 10% nominal return, on average; when 10-yr bonds are 2%, that implies 6% nominal return, on average.

    Investors with expectations that they’ll earn > 6% with diversified passive portfolios spread across bonds/stocks are in for a shocker…but that still doesn’t imply that stocks are ‘overvalued.’ It simply implies that nominal asset returns aren’t going to be that high in the future.

  • Mark

    In regards to risk-free rates on asset pricing, one observations I have over past one year after I interviewed a few bottom-up process driven investment managers is that they actually dont calculate cost of equity based on risk-free rates but a constant % when discounted cash flows…any comments on that ?

  • Well, they should probably review their finance 101 notes or review this class: http://www.alphaarchitect.com/blog/2014/08/16/introduction-to-finance-class-8/

    Discount rates, at the most basic level can be described as follows: DR = RF + risk premium.

    You have to get the RF component because a capital provider can just put the cash in bonds and earn that. Next you gotta compensate a capital provider for dealing with the risk of the project/business/etc. This is tricky and can be all over the map, depending on the circumstances.

    However, there is no reason why a “flat” discount rate makes any sense if the “RF” component has changed a lot. For example, discount rates in the 1980’s should be higher than discount rates today because the “RF” component has went from really high to really low.

    Of course, sometimes “rules of thumb” can be helpful. If estimating risk premium is incredibly noisy, an investor may avoid a lot of problems and minimize their brain damage by simply requiring a fixed rate of return. This is akin to the decision to do 1/N asset allocation as opposed to mean-variance-analysis. Sure, the 1/N is stupid and the MVA stuff is theoretically better, but sometimes simple models beat complex models.

    Anyway, great question, and there are lot of ways one can think about this…

  • Mark

    Thanks for the comments…just in case you may be interested, the Morningstar Equity&Credit Team is currently using the flat discounted rate.

  • PaulieWalnuts

    Thanks for the info, Wes… Any chance you know if the data looks similar if you run this on a broader set of stocks (e.g., the Wilshire 5000, Russell 3000, etc.)?

  • Greg

    Hi Wesley,
    Good article but even better book (Quantitative Value). I noticed the ratio TEV/EBITDA being used frequently here whereas in the book, it was all about EBIT/TEV. Not sure if I missed something, but is there a reason why EBIT/TEV has taken a back seat? Thanks!

  • Robert Geller

    what happens to these historic valuations when take into account that corporate top line is not growing at the same rate as was the case in the historic averages you’re comparing to, and the GDP is growing at half-the-rate compared to these historic valuations, and corporate margins are already 50% higher than those which were present when these historic valuations took place? If we reduce the frame to last 25 years and compare to interest rates during this period than why not also include economic gdp growth, corporate revenue growth, and profit margins, perhaps than we can see that we are getting average valuations but for far worse than average revenue growth and profit margins stretched to the max by cost cutting, setting ourselves up for a snapback to below average reality?

  • MrDodge

    Wesley, Are you familiar with the work of Andrew Smithers? some links:
    http://www.smithers.co.uk/page.php?id=34
    book

    “Wall Street Revalued: Imperfect Markets and Inept Central Bankers” 2009

  • Hi Robert,

    We’ve built our a full-scale return forecasting model here: http://www.alphaarchitect.com/blog/2014/07/14/a-hands-on-lesson-in-return-forecasting-models/#.VQq-g_zF9MU

    It incorporates a lot of the things you mentioned and suggests that nominal returns will be low in the future.

  • essentially 6 of 1; half a dozen of the other. The TEV/EBITDA market data was easier to access.

  • not sure the stats are as accessible. Let me ask my analyst

  • nope, but thanks for sharing.

  • woof

    great. looking forward to see if the combo of them can somehow add value