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.

 

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