Do Valuations Matter?

By Craig Basinger, CFA

When it comes to reading or listening to commentaries about the market, how often do you come across someone saying “it is expensive” or “the market is cheap”? Take today for example; most would agree the market is expensive, but what does that even mean? Expensive vs. what? Its historical valuation or against other asset classes, perhaps? And what is a market valuation metric? Usually it is the aggregate valuation of the underlying companies, or a weighted average. I love math. I love it enough to know you can hide or easily be misled by averages. In this edition of Market Ethos, we are diving down the valuation rabbit hole and will tie it into today’s environment. If it sounds too dull, let’s spoil the ending by saying yes, this market is expensive. However, you will have to read on if you want to know if that matters at all for investing.

The Market Multiple

This is generally understood to be the price of the index divided by the aggregate earnings of the index constituents. The price is the easy part: it is the index level. The earnings are the hard part. Often it is the trailing 12 months of earnings for each company, yet this is somewhat backward looking. The companies already earned and reported that money, so buying today gives no call or right of ownership of these past results. Forward consensus earnings are better, in our view. Although you then must accept these are best-guess forecasts. Forecasts change over time and in the end, reality does not always equal the forecast (in case you haven’t noticed!).

There are also some extremes such as the Shiller P/E ratio, which uses inflationary-adjusted earnings over the past 10 years. The goal is to normalize earnings over an entire cycle. However, if you agree that trailing 12-month earnings are backward looking, going back 10 years is even more so.

The table below contrasts different valuation approaches. A few other tricky aspects include negative earnings and how to weigh all earnings. Does a company losing $100 million offset a company earning $100 million? So from a valuation perspective, the two companies together have no value? It doesn’t sound right, and when WorldCom booked massive losses years ago, it made the market multiple move materially higher as it depressed aggregate earnings for the whole index. Then how to weigh earnings ? Most aggregate all the underlying earnings in the index. Yet , if you are considering buying the index, shouldn’t the company weights in the index drive their representation in the market multiple?


None of these factors negate or diminish the use of valuations, but one should understand some of the potential shortcomings and the math.


Read more


This material is provided for general information and is not to be construed as an offer or solicitation for the sale or purchase of securities mentioned herein. Past performance may not be repeated. Every effort has been made to compile this material from reliable sources however no warranty can be made as to its accuracy or completeness. Before acting on any of the above, please seek individual financial advice based on your personal circumstances. However, neither the author nor Richardson GMP Limited makes any representation or warranty, expressed or implied, in respect thereof, or takes any responsibility for any errors or omissions which may be contained herein or accepts any liability whatsoever for any loss arising from any use or reliance on this report or its contents. Richardson GMP Limited is a member of Canadian Investor Protection Fund. Richardson is a trade-mark of James Richardson & Sons, Limited. GMP is a registered trade-mark of GMP Securities L.P. Both used under license by Richardson GMP Limited.

Certain statements in this document are forward-looking. Forward-looking statements (“FLS”) are statements that are predictive in nature, depend on or refer to future events or conditions, or that include words such as “may,” “will,” “should,” “could,” “expect,” “anticipate,” intend,” “plan,” “believe,” “estimate” or other similar expressions. Statements that look forward in time or include anything other than historical information are subject to risks and uncertainties, and actual results, actions or events could differ materially from those set forth in the FLS. FLS are not guarantees of future performance and are by their nature based on numerous assumptions. Although the FLS contained in this document are based upon what Purpose Investments [and the portfolio manager] believe to be reasonable assumptions, Purpose Investments [and the portfolio manager] cannot assure that actual results will be consistent with these FLS. The reader is cautioned to consider the FLS carefully and not to place undue reliance on the FLS. Unless required by applicable law, it is not undertaken, and specifically disclaimed, that there is any intention or obligation to update or revise FLS, whether as a result of new information, future events or otherwise.

Return to Blog