This article was first published on the Humble Dollar
THERE ARE MANY WAYS to gauge whether individual stocks and the overall market are expensive. But which valuation metric should you rely on?
The fact is, you can find metrics to buttress any market narrative you want to believe. Such confirmation bias can prompt investors to make big changes to their mix of stocks and more conservative investments—sometimes with disastrous results.
As a market analyst, writer and former university finance instructor, I’m familiar with a host of valuation tools. But I take each with a grain of salt. Here are five of the most common market metrics:
1. Price-to-cash flow
This multiple takes the price of a stock and compares it to the firm’s operating cash flow per share. Cash flow is different from net income. It adds back non-cash charges, such as depreciation and amortization, to a company’s reported earnings. It can give you a better sense of the true worth of, say, a big industrial firm that has a large amount of fixed assets that decay in value over time.
Cash flow can also be helpful because it’s thought to be less easily manipulated than net income. I like to look at a company’s free cash flow, which further backs out capital expenditures. You can think of free cash flow as the cash that’s potentially available to a company’s creditors and stockholders. For the S&P 500’s current price-to-cash-flow ratio, check out J.P. Morgan Asset Management’s monthly Guide to the Markets.
2. Price-Earnings
The P/E multiple is perhaps the most widely cited valuation measure. It’s simply a company’s stock price divided by its earnings per share. You can use actual (sometimes called “trailing 12-month”) or forward (estimated) earnings. I prefer to use estimated corporate profits. While never perfect, I believe it’s better to use expected earnings rather than past figures—because future corporate profits are what investors care about.
It’s important to recognize that today’s market P/E ought to be higher than those seen over the past century for two reasons. First, we have lower interest rates, which make stocks more attractive relative to the main investment alternative, bonds. Second, the technology sector is now a bigger share of the U.S. market compared to past decades, and tech stocks typically sport higher P/E ratios thanks to their faster growth.
3. Cyclically Adjusted Price Earnings
Critics of the standard P/E ratio claim, with good reason, that it can be overly volatile—and hence misleading—given the big swings in corporate earnings caused by the economic cycle. Such skeptics often turn instead to the cyclically adjusted P/E ratio.
Also known as CAPE or the Shiller P/E, it uses the average corporate earnings from the past 10 years, with those earnings adjusted for inflation. The problem is because it uses the previous decade’s worth of data, the CAPE is very much a lagging indicator. Also, after periods of accelerating earnings growth and a bull market, the CAPE will almost invariably indicate that stocks are overvalued.
The S&P 500’s CAPE averaged 14.5 from 1872 through 1991. Since then, the average is above 27. Had you relied on this ratio to time the market, you’d have been stuck on the sidelines for the past few decades, waiting for far lower share prices that never materialized. My go-to site for all things CAPE is Multpl.com. J.P. Morgan’s Guide to the Markets also lists the S&P 500’s current CAPE.
4. Price-To-Book Value
This ratio is often used by value investors to hunt for bargains. It compares a stock’s price to the firm’s book value—total assets minus total liabilities—expressed on a per-share basis. The gauge is often used to assess banks and other companies in the financial sector. A reading below one—meaning the share price is below book value—is generally thought to indicate an attractive valuation.
Price-to-book value falls short, however, when comparing companies across countries since accounting standards differ. It also falls short when gauging high-growth tech stocks, because such companies usually have little in the way of tangible assets.
5. Tobin’s Q
This involves dividing the market value of a firm by the replacement value of the company’s assets. You can think of it as an attempt to compare a company’s stock market value to the intrinsic value of its assets. The ratio is applied to both individual stocks and the broad market. Like book value, it’s focused on asset values—and differs from P/Es and price-to-cash flow, which ignore assets and instead focus on profits from a company’s operations.
A Tobin Q ratio below one is thought to be a buy signal, while more than one says the stock is more expensive than its true worth. Like the CAPE ratio, Tobin’s Q tells us the overall stock market is expensive right now, but that’s likely because the S&P 500 is now so dominated by technology firms. Check out Advisor Perspectives to see a monthly chart of Tobin’s Q. Alternatively, go to YCharts or the Federal Reserve Bank of St. Louis.
Feeling overwhelmed by all the ways to value individual stocks and the overall market? Even the pros are often uncertain about whether stocks are a good buy. Count me among those who believe that all this valuation information is, for the most part, reflected in current share prices, so it’s foolhardy to trade based on one or more of the above measuring sticks. Still, it’s helpful to have some sense of how stocks are valued today versus history—because it can prevent us from getting overly exuberant or overly bearish.
This article was first published on The Humble Dollar.