SERIOUS MONEY:THE VALUATION of common stocks is the cornerstone of successful investment, yet it is the least understood. Valuation drives long-term returns and the ability to perform a well-constructed analysis can boost performance. Unfortunately, the majority of so-called investment experts appear incapable of performing a valid valuation exercise and, not surprisingly, client returns suffer.
The standard analysis calculates the price/earnings ratio on one-year forward operating earnings and then compares the resulting multiple to a historical average based on trailing 12-month earnings. The obvious bias created by the comparison of a future multiple with historical averages appears to be lost on practitioners. Additionally, the forward estimates of earnings are typically biased upwards and calculated before write-offs, while the historical earnings used for comparison purposes are net of exceptional and extraordinary charges.
Not surprisingly, such faulty analysis almost always leads to the conclusion that stocks are cheap.
Furthermore, the historical comparisons are invalid as they typically span a period of no more than 20 years. This limited sample is not statistically significant and artificially inflates the average price multiples used for comparison as the data set includes the bubble-era valuations of the late-1990s.
It is hardly surprising that stocks look cheap when value is assessed relative to the most expensive valuations in US stock-market history.
Perhaps the most damning evidence against the use of single-point estimates is the fact that they have limited predictive ability. The price/earnings ratio has mean-reverting properties but, unfortunately, the eventual adjustment to a single-point multiple typically occurs through earnings changes and not through price. Thus, even if the analysis is properly constructed, it simply doesn't add value.
The highly-paid investment experts are not done yet. Out of their toolbox springs the so-called Fed model, which compares the earnings yield on stocks - the inverse of the price/earnings multiple - with the yield available on long-term Treasury bonds.
Some routinely argue that stocks look extraordinarily cheap on this basis before the consideration of long-term growth prospects. Unfortunately, such experts are clearly unaware that the earnings yield, which approximates the long-term expected real returns to stocks, includes anticipated capital appreciation. The use of relatively simple algebraic equations demonstrates that the earnings yield equals the dividend yield plus expected long-term real growth.
Furthermore, use of the Fed model is theoretically invalid, as investors are erroneously comparing a real variable with a nominal one. Stocks are a claim on real assets and the cash flows thereof should appreciate with inflation, while bonds are unambiguously a claim on nominal cash flows. Inflation clearly affects bond yields but it should not affect earnings yields, as a change in the discount rate should be offset by an equal change in the growth rate of dividends.
Investors fail to appreciate that inflation reduces the value of fixed-rate debt, which increases the value of equity. Even if the comparison was theoretically valid, the model requires implausible assumptions, but the most damning case against its use is the evidence that it simply doesn't work in practice.
A properly constructed price/ earnings analysis should assess the stock market's long-term earnings power. The use of relatively simple regression techniques generates an estimate of $62 per share for trend earnings. It is worth noting that corporate earnings track gross domestic product growth quite closely through time. However, per share, earnings growth is roughly one percentage point less, at 2.5 per cent, due to the creation of new businesses, which are the engine of growth in developed economies.
The price/earnings multiple is roughly 20 times trend profits for an earnings yield of 5 per cent. Note also that the dividend yield plus real growth also delivers a long-term real return projection of 5 per cent, as would be expected from a sound analysis. The expected return is two percentage points below historical returns, so stocks cannot be described as cheap. However, lower tax rates and the reduced cost of building a well-diversified portfolio can explain at least half of the reduction in expectations. Trend analysis confirms that the normalised price/earnings multiple is mean-reverting and that the ratio has predictive ability.
It is important to note that mean reversion does not imply valuations return to their long-term average. They drop below normal levels such that the long-term average is maintained.
Secular bear markets do not end at fair value, and stocks are not cheap.
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