SEARCHING FOR VALUE: EQUITY MARKET VALUATIONS HOME AND AWAY - Barney Whiter Senior Managing Director Corporate Finance/ Restructuring Valuation ...
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February 2014 SEARCHING FOR VALUE: EQUITY MARKET VALUATIONS HOME AND AWAY Barney Whiter Senior Managing Director Corporate Finance/ Restructuring Valuation and Financial Advisory Services FTI Consulting
February 2014
U.S. equity markets have bounced back, and market valuation metrics
now appear stretched even as prospective returns on investment are
being compressed. Are U.S. equities overvalued? Should investors
balance their portfolios by looking elsewhere for higher returns?
What’s going on? and other central banks. QE has driven For investors, entry points at higher
interest rates and borrowing costs to valuations are associated with lower
U.S. equity market performance has record lows, allowing corporations expected returns. This leads to these
been strong in recent years, with the and consumers breathing space in questions: Are U.S. equity markets now
Standard & Poor’s (S&P) 500 reaching a which to refinance, extend maturities overvalued? And if they are, should
new high on Jan. 15, 2014 of 1,848, some to improve returns and begin lowering global investors look to international
18 percent higher than the pre-Lehman debt burdens. While the stated markets for lower initial valuations and
meltdown peak of 1,565 in October 2007 objective of QE is to spur and support hence higher potential returns?
and 173 percent higher than the March economic growth in the real economy,
2009 low of 677. Furthermore, fuelled its side effects in the financial world To answer these questions, we need
by the ready availability of low-cost arguably have been just as (if not to look at how equity markets can be
debt, there are signs that investor risk more) significant. QE has helped drive valued and the reliability of the methods
appetite and corporate activity have treasury bonds higher, resulting in used to value the markets.
strengthened over the past 12 months. yields on treasuries and alternative fixed
Examples include the Verizon/Vodafone income instruments (such as money The limits of P/E multiples
acquisition (the largest merger and market and deposit accounts) that by The price to earnings (P/E) multiple
acquisition (M&A) transaction since historical standards are very low. Yields is the most ubiquitous measure of
2007) and the strengthening of the on investment grade debt worldwide valuation in publicly traded equities.
initial public offering (IPO) market in the dropped to record lows during 2013, Thus, a natural starting point to
United States (Twitter, Hilton) and in the with the Bloomberg Global Investment determine whether the U.S. market is
UK (Royal Mail, Merlin Entertainments, Grade Corporate Bond Index now overvalued is to compare today’s P/E
Foxtons), as well as strong demand for yielding just 2.6 percent. with historical P/E ratios (see Figure
high-yield debt issuance. 1). On Jan. 22, 2014, the S&P 500 P/E
All this financial market exuberance multiple stood at 17.2x, slightly above
This spectacular recovery in the equity stands in marked contrast to a its long-term average of 16.4x.
market since 2009, and the concomitant real economy that remains more
upsurge in M&As and IPOs, has been constrained, with U.S. unemployment The S&P 500 has run ahead, but
associated by many with quantitative stuck at 7 percent1 and consumer P/Es are broadly in line with the
easing (QE) by the Federal Reserve confidence remaining tepid. historical average.
2,000 35x
1,800
30x
1,600
Price/trailing 12 months earnings
1,400 25x Average:
16.4x
1,200
20x
Index Price
1,000
800 15x
600 10x
400
5x
200
0 0x
Jan 54
Jan 59
Jan 64
Jan 69
Jan 74
Jan 79
Jan 84
Jan 89
Jan 94
Jan 99
Jan 04
Jan 09
Jan 54
Jan 59
Jan 64
Jan 69
Jan 74
Jan 79
Jan 84
Jan 89
Jan 94
Jan 99
Jan 04
Jan 09
Figure 1 – S&P 500: 1954 to January 2014 1
1 — Source: Bloomberg 2February 2014
However, investors should be wary of At the same time, inflation expectations borrowings). In a downturn, the same
relying solely on simple P/E multiples currently appear well-anchored, effect works in reverse. Small percentage
to assess valuation. Single period although the long-term effects of QE declines in revenues quickly can wipe
P/E multiples can be distorted by a are yet to be seen. Low, stable levels of out a large proportion of earnings.
number of factors, including corporate inflation and interest rates historically
accounting policies, the impact of have been associated with investor The cyclicality of earnings is illustrated
inflation and, most important, the willingness to pay higher P/Es. in Figure 2, which depicts U.S. corporate
cyclical nature of the economy. profits as a share of gross domestic
But the biggest potential pitfall of relying product (GDP). This chart suggests
There is some evidence that, over time, on simple P/E is due to the variability that while corporate profit margins
corporate earnings may be somewhat of corporate earnings across economic typically revert to the mean over time,
overstated vs. cash flow-based cycles. By focusing on valuations based profit margins currently are higher
measures. However, there is no evidence on P/E multiples, the investor implicitly than historical norms. This implies
that this divergence between cash and assumes the earnings figure is both that the “E” in the P/E multiple may be
accounting profits has increased in normal and sustainable. In practice, elevated temporarily, and, therefore,
recent years. Indeed, the reverse seems however, corporate earnings are volatile. P/E multiples may appear lower
more likely given the convergence of In an upswing, increases in revenues than they would be if reviewed over
U.S. Generally Accepted Accounting boost earnings given (relatively) fixed time. Globalization (leading to lower
Principles and International Financial operational costs (such as overhead) corporate costs through labor arbitrage),
Reporting Standards in recent years. and financial charges (such as bond government stimuli and low savings
coupons and the interest on bank rates (the last two indicating higher
14%
13%
12%
11% Average:
8.9%
GDP / Corporate profits
10%
9%
8%
7%
6%
5%
4%
Mar 69
Mar 74
Mar 79
Mar 84
Mar 89
Mar 94
Mar 99
Mar 04
Mar 09
Figure 2 – U.S. corporate profits as a share of GDP 2
demand and spending) all have been CAPE: A metric for providing investors and analysts a more
cited as potential causes of today’s stable measure of earnings for valuation
elevated corporate earnings. turbulent times? purposes. Comparing the current CAPE
with the long-term average CAPE then
The earnings cyclicality illustrated One valuation method that takes the should present investors with a more
in Figure 2 suggests that we need a above factors into account and is widely reliable assessment of whether or not
measure that takes into account the used to gauge whether stock markets the current market is overpriced.
peaks and troughs of earnings over one (in the aggregate) may be cheap or
or more full business cycles. Any single expensive is the cyclically adjusted price A low CAPE should be associated with
year’s earnings are too volatile to offer earnings (CAPE) ratio developed and stronger subsequent price performance
a solid indication of the underlying popularized by Yale professor Robert and higher investor returns over time
earning power of any individual Shiller. as the market returns to fair value.
company or index. Therefore, averaging, Conversely, a high CAPE, indicating
or otherwise smoothing earnings over CAPE takes an index level (the S&P over-valuation, eventually should
a longer period, would provide a more 500) and divides this by the average be associated with weaker price
appropriate measure of earnings for real reported earnings over the prior performance and lower investor returns.
assessing value. 10 years. Real, in this sense, means
adjusting historical earnings for the The current CAPE ratio for the S&P 500 is
impact of inflation. Averaging over 10 around 25.0x, approximately 52 percent
years smoothes out peaks and troughs, higher than the long-term average of
2—Source: U.S. Bureau of Economic Analysis. Calculated as “corporate profits with inventory valuation
and capital consumption adjustments” divided by GDP.
3February 2014
50.0x
45.0x Dot Com
Boom
40.0x
35.0x 1929 – pre-
Wall Street
30.0x crash
25.0x
20.0x
15.0x
10.0x Credit
Crash
5.0x
0.0x
1881 1894 1907 1920 1933 1946 1959 1972 1985 1998 2011
CAPE Long-term average
Figure 3 – S&P 500 CAPE 1881 to 2013 3
16.5x. This strongly suggests that (at CAPE, however, is only a single the strongest results, accounting for 43
least in historical terms) the U.S. stock valuation metric among many. One may percent of the variation in real returns.
market currently is trading above fair reasonably ask for empirical evidence This closely was followed by simple
value (albeit much less so than at the of how reliable different measures of price: trailing 12 months earnings. In
2000 peak of the dot.com boom). valuation have been. The Vanguard other words, lower starting PEs (both
Group (Vanguard) researched U.S. simple PEs and CAPE) significantly
Historically, extreme levels of CAPE have equity returns since 1926 to assess correlate with higher future returns
been associated with subsequent poor the predictive power of a range of (price appreciation plus dividends).
market returns. Figure 3 shows that the alternative valuation metrics. Figure 4
current CAPE has been higher only on illustrates the correlation (quantified as (Interestingly, commonly cited reasons
three occasions in the past 100+ years: R2) of each metric with subsequent 10- for high or low valuations such as GDP or
before the 1929 crash (peak CAPE 32.6x in year returns. corporate earnings growth had almost
September 1929), before the 2000 dot.com no predictive power. Indeed, rainfall
crash (peak CAPE 44.2x in December 1999) Vanguard found that many commonly had similar predictive accuracy, a factor
and before the 2008 credit crash (peak used valuation metrics (such as chosen to provide comparison with an
CAPE 27.5x in May 2007). dividend yield) had limited use in obviously useless metric).
forecasting future returns. Of the various
metrics tested, Shiller’s CAPE produced
1
Proportion of variance explained
0.9
0.8 R2 = 1.00: Very strong predictability
0.7
0.6
0.5 0.43
0.38 R2 =0: Very weak predictability
0.4
0.3 0.23
0.2 0.19 0.18 0.18 0.16
0.1 0.06 0.06 0.05
0.01 0.01 0.01 0.00 0.00 0.00
0
10-year ahead real returns
Figure 4 – Proportion of future stock returns explained by various metrics4
It should be borne in mind that, in the correlations having an R2 close to zero. measures can provide signs of over- or
short term, expensive markets always In other words, even if CAPE tells us the undervaluation in equity markets that
can move higher and cheap markets market is overvalued, this would not eventually have consequences and can
always can drop lower. Vanguard necessarily correlate with lower future be a warning signal for investors.
found that short-term stock returns returns in the short term. However,
essentially are unpredictable, with most the evidence does suggest that certain
3—Source: Robert Shiller CAPE data
4—The Vanguard Group research, October 2012: “Forecasting stock returns: 4
What signals matter, and what do they say now?”February 2014
Warning signals: do validate its warning. These methods Using the market value of all publicly
include comparing total market traded securities as a percentage of GNP
Not just CAPE capitalization of the stock market to is a favorite of Warren Buffett’s to assess
There are other long-term valuation GDP, total market capitalization to aggregate equity market valuations. In
approaches that can be used to cross corporate revenues and the q ratio (ratio 2001, he said:
check CAPE, and, today, many, indeed, of market price to replacement cost).
“[T]he market value of all publicly traded securities as a percentage of
the country’s business — that is, as a percentage of GNP — has certain
limitations in telling you what you need to know. Still, it is probably the
best single measure of where valuations stand at any given moment. And
as you can see, nearly two years ago, the ratio rose to an unprecedented
level. That should have been a very strong warning signal.”
Figure 5 shows that the current ratio
of total market capitalization to GNP 1.6x
of just above 1.0x is higher than the 1.4x
average over the past 40 years. While 1.2x
the number is lower than the ratio 1.0x Average:
achieved in the last two peaks (1999 0.7x
0.8x
and 2007), Buffett’s advice suggests
this now should be a warning signal to 0.6x
investors. 0.4x
0.2x
We also can consider the ratio of U.S. 0.0x
equity prices to U.S. corporate sales.
Dec - 70
Dec - 75
Dec - 85
Dec - 90
Dec - 00
Dec - 05
Dec - 10
While sales may not always translate
into profits and cash flows (the true
drivers of value), price to revenue
multiples can be a useful high-level Figure 5 – U.S. stock market vs. GNP 5
indicator of market valuation given
that revenues are much less cyclical
than earnings (and hence less prone
to distorting a calculation in any given
year). 2.5x
2.0x
Figure 6 shows the movement in price
to sales ratio for the S&P 500. While
1.5x
the ratio typically has been above 1.0x Average:
0.9x
since June 1995, today’s ratio of 1.6x
1.0x
now is back to pre-Lehman levels and
is approximately 79 percent higher than 0.5x
the long-term average of 0.9x.
0.0x
Tobin’s q ratio provides another
Jan-73
Jan-78
Jan-83
Jan-88
Jan-93
Jan-98
Jan-03
Jan-08
Jan-13
approach used to assess aggregate
market or index valuation. This ratio
compares the combined market value
of all the companies listed on a stock Figure 6 – S&P price vs. sales 6
market with the replacement cost of
5—Source: Bloomberg
6—Source: Bloomberg
5February 2014
their combined assets. A low q ratio
(less than 1.0) means that the market 1.8 200%
value is less than the estimated cost 1.6
150%
to replace all the underlying assets of 1.4
100%
1.2
the constituent corporations and that
Variance to mean
1.0 50%
the stock or index, therefore, may be
Q ratio
0.8
undervalued. A high q ratio (greater 0.6
0%
than 1.0) implies the opposite. 0.4
-50%
Historically, q for the S&P 500 is below 0.2 -100%
1.0 and has averaged approximately 0.7. 0.0
Oct-51
Oct-56
Oct-61
Oct-66
Oct-71
Oct-76
Oct-81
Oct-86
Oct-91
Oct-96
Oct-01
Oct-06
Oct-11
Oct-51
Oct-56
Oct-61
Oct-66
Oct-71
Oct-76
Oct-81
Oct-86
Oct-91
Oct-96
Oct-01
Oct-06
Oct-11
Similar to CAPE, the q ratio should CAPE Q ratio
tend to revert to the mean over time.
When market prices are above asset Figure 7 – Tobin’s q ratio for the United States and how its variance to long-term
replacement costs, it is cheaper for mean compares with CAPE7
investors or corporations to buy assets
directly than it would be for them
to invest in equities (or undertake
acquisitions of public companies) and
30.0x
vice versa. This process of arbitrage
over time causes mean reversion. 25.0x
Figure 7 shows the movement in the 20.0x
q ratio since 1951. This graph shows 15.0x
an almost identical trend to CAPE
both in the short and long term. The 10.0x
current q ratio for the S&P 500 of 0.98
5.0x
is 42 percent higher than its long-term
average of 0.7, again suggesting, like 0.0x
CAPE, that the U.S. stock market now
Greece
Ireland
Russia
Italy
Austria
Spain
Portugal
Brazil
Belgium
Netherlands
Singapore
China
France
United Kingdom
Turkey
South Korea
Germany
Australia
Taiwan
Sweden
Hong Kong
South Africa
Canada
Thailand
India
Switzerland
Mexico
Chile
Japan
Malaysia
U.S.
Indonesia
is trading above fair value.
Searching for value Figure 8 – Country CAPEs
around the world
We live, work and invest in an
interconnected financial world. How 100%
does the United States compare 80%
with international markets? Are they 60%
similarly overvalued? Figure 8 shows 40%
recent absolute CAPEs (averaging all 20%
industry sectors) for a range of the 0%
-20%
world’s biggest economies. The United
-40%
States scored as the second most -60%
expensive market in the world. -80%
-100%
However, absolute CAPEs can be
Greece
Austria
Italy
Japan
Spain
China
Ireland
Singapore
Portugal
Brazil
France
Russia
Belgium
India
Taiwan
Sweden
Germany
South Korea
Turkey
Australia
Hong Kong
Canada
Chile
Netherlands
Mexico
Switzerland
United Kingdom
South Africa
Malaysia
Indonesia
Thaisland
U.S.
misleading as some countries
will tend to have higher average
valuations than others depending
on the mix of sectors and corporate
entities. For example, an index with Figure 9 – Country CAPEs : percentage difference from historic median
a higher weighting in low-growth,
price-regulated utilities would tend to
have lower CAPEs than an index more
7—Sources: Federal Reserve Bank of St Louis and Robert Shiller CAPE data
6February 2014
weighted toward, say, high-growth
technology companies. 40x 140%
35x 120%
Obviously, the macroeconomic outlook
MSCI P/E as a percentage of S&P P/E
30x
100%
and quality of corporate earnings may 25x
80%
be completely different from country 20x
15x 60%
to country. Given continuing banking
P/E
10x 40%
sector stress and sovereign debt levels
5x 20%
in the Eurozone, for example, there are
0x 0%
good reasons why southern European
Mar-95
Mar-97
Mar-99
Mar-01
Mar-03
Mar-05
Mar-07
Mar-09
Mar-11
Mar-13
equity markets should be cheap.
Mar-95
Mar-97
Mar-99
Mar-01
Mar-03
Mar-05
Mar-07
Mar-09
Mar-11
Mar-13
Similarly, the United States arguably
may warrant a premium compared with MSCI Emerging Markets Index S&P
many other markets given its stronger
demographic, innovation and resource Figure 10 – S&P and MSCI Emerging Markets Index P/E comparison8
profile.
we can see that the S&P 500 appears are cyclical, and other historically
However, this does not explain why more fully valued than emerging accurate and reliable valuation
the United States currently trades at a markets not only on an absolute measures indicate that the S&P 500 is
significant premium to its own historic basis but also relative to its historic overpriced. As previously noted, the
median CAPE. In Figure 9, the current relationship with emerging markets. current CAPE ratio for the S&P 500 is
CAPE of each country is compared By expressing the emerging markets’ approximately 52 percent higher than
with its historical median. Again, the P/E ratio as a percentage of the S&P 500 its historical average. This finding is
picture is of a U.S. market that is fully P/E, we see that the current ratio of 66 consistent with the q ratio for the S&P
valued, contrasting with markets in percent is below the 75 percent average 500, currently some 42 percent higher
Europe (e.g., Greece, Austria, Italy) and since March 1995, again suggesting that than its historical average.
some of the emerging markets (e.g., compared with the S&P 500, emerging
China, Brazil) that appear extremely markets are relatively attractively priced. CAPE data also suggest that certain
undervalued. stock markets in emerging markets
Whilst emerging market currencies and and in Europe appear undervalued in
What does the data tell us about the equities have exhibited recent volatility comparison with the United States both
relative valuations of emerging markets and continue to face macro-economic in absolute terms and relative to past
vs. developed markets? Figure 10 adjustment challenges, it appears that relationships. Right now, these markets
shows the P/E comparison between the emerging market valuations may already may offer better value than the United
S&P 500 and emerging markets, based reflect these risks. States so investors could look at this as
on the MSCI Emerging Markets Index. an opportunity to consider diversifying
their portfolios internationally. Broad
Traditionally, the S&P 500 has An argument for diversification is a key to managing risk
traded at a higher P/E ratio than the diversification and, as the old saying goes, is the only
MSCI Emerging Markets Index. The free lunch on Wall Street.
current S&P 500 P/E ratio of c.17.2 is Simple P/E multiples show the S&P
approximately six P/E points higher 500 currently trades in line with its
than the MSCI P/E Index of 11.0x. Thus, historical average. However, earnings
Barney Whiter
Senior Managing Director
Barney Whiter is a valuation specialist and a Senior Managing Corporate Finance/ Restructuring
Director in FTI Consulting’s Corporate Finance/ Restructuring Valuation and Financial Advisory Services
segment in London. The research for this article was performed by FTI Consulting
barney.whiter@fticonsulting.com
FTI Consultants, Richard Hallett and James Excell.
This article reflects the personal views of the authors based on their own research as of December 2013.
This article does not necessarily reflect the views of FTI Consulting. Nothing in this article should be For more information and an online version of
taken to constitute investment advice provided by FTI Consulting or its other professionals. this article, visit ftijournal.com.
8—Source: Bloomberg © 2014 FTI Consulting, Inc. All rights reserved.
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