The Case for Valuation
Valuation ratios measure how expensive stocks are by historical standards. A popular valuation metric is the Price-to-Earnings (P/E) ratio which details how much an investor has to pay to receive $1 in earnings. A P/E ratio can be applied to a company, an industry, a sector or even the entire market. Recently the P/E ratio of the S&P 500 has fallen below levels seen in recent recessions, and while the current P/E ratio does not guarantee that stocks have reached a bottom, it does show that the valuation of the stock market looks attractive relative to its recent historical average.
When utilizing the price-to-earnings ratio as a valuation metric, it is important to recognize that not all P/E ratios are equal. Some P/E ratios are forward looking and are based on analyst estimates of future earnings; other P/E ratios are backward looking and are based on actual earnings. Some use operating earnings which exclude one-time gains or losses; others use reported earnings which include one-time gains or losses. When making comparisons across time, it is critically important to remain consistent with respect to the valuation methodology.
As of March 31, 2009, the trailing twelve-month P/E ratio using reported earnings for the S&P 500 was 17. This level is well below the 20-year average of 23 and the 10-year average of 25. However, concluding that an investment in the stock market is opportunistic simply because the current valuation is lower than the 20-year average may be questionable. The 20-year average includes a bull market that recorded some of the highest P/E ratios in history. In fact, when the bull market of the 1990s peaked in March of 2000, the twelve month trailing P/E ratio of the S&P 500 was at an all-time high of 31.
Given the dramatic decline in market prices since October of 2007, many investors may be wondering why the current trailing twelve-month P/E ratio does not appear even more attractive. The answer is simple: because earnings have fallen substantially as well. In 2008 the earnings of the S&P 500 were $49.54, a decline of 40% from $82.54 in 2007. The reality is that P/E ratios often increase during economic recessions because corporate earnings become so depressed. However, in our current recession, stock valuations appear attractive despite the current depressed state of corporate earnings. But how does the current valuation compare to a 100-year average which is less impacted by the high valuations recorded in the last 20 years?
Professor Robert Shiller from Yale University has conducted research on the valuation of the market going back to the 1880s. To account for periods of volatility in corporate earnings, he calculates a P/E ratio using average inflation-adjusted reported earnings over the trailing 10-year period. One of the benefits of this methodology is that it overcomes the problems associated with artificially depressed earnings at bear market lows.
Using Shiller’s methodology, the market was trading at 13 times trailing earnings on March 31st, a level significantly below the peak of 44 recorded in the year 2000 and the previous peak of 33 recorded in 1929. However, at the March 31st date the market was also trading modestly above the most recent low of 7 recorded in 1982 and the low of 6 recorded in 1932. In order for the current P/E ratio to revisit these historical lows, corporate earnings would have to double without any change in market price, or the market price would have to drop in half without any change to earnings – neither of which appears likely. The average historical P/E ratio using Professor Shiller’s methodology is 16 times earnings, and over half the monthly data points going back to the year 1880 show the market trading above 15 times earnings.
While the current valuation of the broad market looks modestly attractive relative to historical averages, in the near-term it is certainly possible that the P/E ratio using Shiller’s methodology retreats to single-digits, and it is equally possible that it advances to the mid-teens. As equity investors, we should be less concerned about what happens in the near-term and more concerned about what happens over the long-term. The current valuation of the market combined with the potential for greater than average growth in earnings leads us to believe that a long-term investment in equities today looks attractive relative to other periods in history. No one can know whether the market or the P/E ratio has reached a bottom, but we do believe that an investment in equities today will serve investors well over the next five-to-ten years.
Many other valuation metrics currently look considerably more attractive than the P/E ratios we have highlighted. Several examples include Price-to-Book ratios, forward looking P/E ratios and rolling 10-year equity returns in relation to bond returns, among others. We chose to examine one of the most conservative valuation metrics recognizing that if it supported the valuation case for stocks then most other metrics would as well.