Valuations
By: Ben Mcdonald
Tags: Equity, Interest Rates, Valuation, Fixed Income

Prices are signals. Prices provide economies with valuable information in real time. They tell us what we have too much of or what we don’t have enough of. They tell is what people want and what people don’t want. Prices are perhaps the most important feature of a capitalist society as they dictate where and how our finite resources should be allocated.

When it comes to stocks, prices are a little bit fuzzier. If one stock is $50 and anther is $100, does that mean the first is a better value than the second? Of course not. When it comes to stocks, we need to look at them in relation to what we are getting. This is why valuation ratios are always used to measure the value of one stock compared to another, or measure how much value there is in all equities relative to the past or relative to other equities.

There are a ton of valuation ratios (also known as multiples) that each have their pros and cons. Some are certainly better than others, but none have a monopoly on the true intrinsic value of a stock or index. One of the oldest is Price to book value of equity, but it’s not as informative as it was due to the importance of intangible assets these days (not fully captured on balance sheets), accounting treatment of long term assets like land (doesn’t grow in value), and buybacks (decreases book value which increases price to book ratios). Price to sales is another and it serves a purpose, but investors don’t get to keep revenue. Expenses matter so companies with better margins should have a better P/S, all else equal.

Price to earnings is a popular one that we use a lot, as it puts the price of a stock in relation to after tax earnings which investors keep either in the form of dividends or retained earnings. There are many versions of P/E ratios. Should we look at trailing 12 months earnings? Maybe inflation adjusted earnings from last 120 months like CAPE ratios do so that we smooth cyclical changes in earnings? Maybe expectations of next 12 months as investors are discounting future cash flows, not past ones? As mentioned, none of these are perfect.

There are also ones that might be even more relevant. Many of the best managers talk about how cash flows are important because earnings feature too many accounting opinions whereas cash flows are less fungible. Price to cash flows look at how much a stock is worth relative to its cash flows from operations. The big drawback here is that other cash flows matter too, like investment ones (the difference between expenses and investments aren’t always easy to decipher).

Another popular measure, especially in private markets, is EV (Enterprise Value) to EBITDA (Earnings before Interest, Tax, Depreciation, and Amortization). Enterprise value a companies debt plus their equity minus their cash (they subtract cash because if they didn’t, a company could just grow their EV by increasing borrowing and keeping it in cash). EBITDA is your operating earning before you’ve paid your debt and equity holders (and the government), so it makes more sense to compare EBITDA to the value of the whole firm. There are, of course, drawbacks here too. Depreciation might not be a cash flow but it is representative of future investments required to maintain operations.

There are plenty more ratios as well but the ones described above are the most popular. Why they are the most popular is up for debate, but it centers around the fact that each are relatively easy to calculate and they have each been shown to be relatively informative over time. There are a few things missing from all of them though. First is growth rates. As mentioned, investors are discounting future cash flows, not past, so if growth rates are higher going forward, then they deserve higher multiples. The second is the value in other asset classes. If we are in a world where you can buy a GIC for 10%, then the relative attractiveness of equities is less than a world where a GIC’s are offering 1%, which may mean that higher multiples make sense in the latter case.

Either way, it still makes sense to follow these metrics as it informs us how much value could be in equities and what the market expects with respect to equities going forward. Let’s take a look at what these valuation ratios have done over past 20 years.

First let’s look at EV/EBITDA. This one is interesting as it is the only one that shows Canada as being relatively expensive. I don’t know why this is as most multiples show Canada as being relatively attractive. I’ll try to dig into this further when I find some time.

Apologies for the data being a few months old. I wrote this a while ago and was too lazy to update charts.

Next let’s look at P/B ratios. Here you can see a major divergence between US and the rest of the world. You’ll see a divergence between US and everyone else in all measures, but this one is the worst. I’m not exactly sure why, but it’s like due to the huge value of intangibles on tech and communication companies which aren’t captured on balance sheets. Another issue is buybacks which are most popular in US. To be honest, not many give P/B ratios much credence anymore for a number of reasons. In what world does it make sense for McDonald’s to have a negative book value of equity?

Price to cash flow shows that valuations are high and US but not bad in the rest of the world, especially EAFE countries (DM ex-US). Europe has been a popular overweight for many active managers over the years due to valuation differences and you can see why here.

Now let’s dive into the various types of PE ratios we have at our disposal. First there’s price to earnings over trailing twelve months (TTM). You can see that things are looking very frothy as one of the worst earnings quarters ever are being incorporated into the multiple. For perspective, this number reached just over 30 in the tech bubble in both the US and EAFE.

As mentioned before, investors only care about future cash flows, so let’s see what investors are pricing stocks using expected earnings over next 12 months. As you can see below, the picture isn’t much better. This is likely due to the fact that investors expect earnings to be pretty terrible over the next 12 months. I track earnings expectations as far into the future as I/B/E/S (Institutional Brokers Estimate Systems) have estimates for. Right now 2020 earnings estimates for the S&P 500 is $124, but in 2022 investors expect earnings to jump back to $170. This would imply a PE ratio of 20. Still high relative to history, but not as bubbly as the below would appear.

This truth of the matter is that the nature of this crisis has been a “sudden stop” of sorts. Earnings so far have been awful, and investors think they will be bad over next year or two, but they will come back after pandemic. A weird accounting quirk in the US allows companies to take losses back 5 years which incentivizes companies to take as big of losses as possible this year (tax rate is 21% now, but was 35% less than 5 years ago, so taking losses back is extremely valuable). This may be why valuations which narrowly look at trailing or future 12 months look extreme.

This is also why CAPE ratios are more informative right now. Cyclically-adjusted PE ratios look at earnings over past 10 years so it smooths out massive bumps like this. When looking at CAPE ratios, they are pretty high in US as they have been for last number of years. Other markets generally look reasonably priced compared to long term earnings, and EM is looking very attractive.

So far we have only discussed equities in relation to their past multiples. Obviously investors have a wider opportunity set, so the value in other asset classes matter. One way to compare equities to fixed income is if we flip our multiples. A bond’s yield is the coupon over the value of the bond. Equity’s yield can be thought of the earnings over the price. So if we flip our CAPE multiple, that gives us our CAPE earnings yield which is directly comparable to fixed income yields. If we subtract bond yields from earnings yields, we get the premium we are paid for taking on equity risk (also known as the equity risk premium). This also doesn’t account for growth, by the way, as equities have growing earnings whereas a bond’s coupons are fixed.

If we look at CAPE yields less US 10 year bonds, we can see that the equity risk premium is quite large relative to the past 15 years. This number was actually negative for much of 80’s and 90’s. As you can guess, this isn’t because equities have become more attractive, but because bonds have become extremely unattractive.

US and Canadian 10 year yields have plummeted over past 15 years. The compression of government yields has meant investors have had to take on more risk to meet planning objectives. Some refer to this as TINA (there is no alternative). If all investors are pushed into equities, this raises the demand for equities which pushes up prices for equities, just like how an increase demand pushes up the price of any other good.

Of course we didn’t mention corporate fixed income, or credit, at all so far. Spreads between credits and governments are starting to become tighter than median and I expect them to get much tighter given how much support there is in that market from the Fed, as well as the added demand there will be from fixed income investors chasing yield.

This year has been an outlier. No one expected a pandemic would shutdown the globe. Even if you did expect that, there’s a 0% chance you would have thought markets would be flat 6 months into the pandemic. The divergence of asset values and the fundamental economy has been the story of the year, with many left clueless as to how that could be. If you ask me, the main reason for why equities have performed so well YTD is because TINA.