Valuation -- Reading the Roadmap

Prices matter in almost all of our purchases, both personal and professional. Investors seek value when placing their capital. An old hand at the investment business once told me, “Equity market investors are all growth investors – growth and value investors just have different parameters on what they will pay for growth.” With this in mind, value is in the eye of the beholder..

With the upward move in the world’s equity markets over the last five years, I thought it appropriate to provide some insight on equity market valuation based on historical norms.

Basics Behind Methodology

Valuation can be viewed through two prisms – absolute and relative. Today, I focus on global equity relative valuation levels and provide data to help read the valuation roadmap. In other words, we will examine which markets look cheap and which markets look overvalued. I will provide relative valuation data using four valuation factors – Price to Earnings (P/E), Price to Cash Flow (P/CF), Price to Book Value (P/BV) and Dividend Yield (DY). I will provide historical data over two timeframes – 40 years and 20 years.

Why look at these valuation measures? Because the four measures utilize data from all three major financial statements – the income statement, the cash flow statement and the balance sheet. This methodology is much more robust than simply looking at P/E ratios.

Why view this information by comparing today’s valuation measures to both 40- and 20-year time horizons? Generally, the longer-term the data stream, the more relative information points we can gather to make our analysis. Over the last 40 years, we have information regarding how global investors valued markets during times of war, peace, high inflation, low inflation, rapid GDP growth and deep recessions. In other words, we can make comparisons that are all-encompassing.

If this is the case, why should we bother studying shorter-term relative valuation standards, such as over the last 20 years? Simply put, a shorter-term time horizon captures today’s investor attitudes and biases, whereas a 40-year time horizon also captures yesterday’s investor attitudes. I consider both longer-term and shorter-term relative valuation studies useful.

The raw data shown in the table below refers to MSCI Indexes. Consequently, the numbers don’t match with the more common segmented indexes (Dow Jones and S&P 500, for example), but are consistent with each other, globally. Additionally, notice that the Emerging Market information isn’t included on the 40-year historical information. This is because the Emerging Markets haven’t yet been incorporated in an index fashion for 40 years. As a matter of fact, the EAFE didn’t exist until the early 1970s. It is also important to note that the data is shown on a trailing basis, rather than a projected basis.

The following data is laid out in block formation per valuation parameter.

Findings

First and foremost, I have found valuation a poor timing tool. Many other factors need to be considered when making an investment other than simply looking at valuation. That being said, following are my general findings from the table above:

• According to the raw data, globally, the equity markets are currently overvalued by 13% on average, when compared to 40 years of historical data.
• The United States is leading the way in the overvaluation parade and is currently 32% overvalued when compared to 40 years of history. While this is a sizeable level of overvaluation, it is interesting to note that, by these metrics, at the peak of pricing and valuation during the year 2000, the U.S. market was 52% overvalued.
• Outside the United States, valuation levels are not nearly as extended. Relative to its 40-year valuation history, the EAFE Index is currently 3% overvalued.
• Things get more tame when we look at current valuation as compared to the past 20-year period. By these measures, all markets observed appear undervalued as compared to their 20-year valuation bands.
• What about forward earnings? Stocks are discounting assets, with current valuations reflecting not necessarily what has happened in the past, but what investors believe will occur in the future. With this in mind, it is important to understand that using a forward four-quarter analysis, the United States is currently priced around 16x earnings – about a 10% premium to its 40-year valuation average.
• What of individual markets? What is currently the cheapest market? Probably Russia. At 5.1x earnings, 4.7% dividend yield, .6x book value and 3.3x cash flow, Russia is an extremely “cheap” market. Beware – at times cheap markets are cheap for good reasons. If an investor is interested in a cheap market and doesn’t want to poke the Russian Bear, look at the Czech market. It’s about as cheap as Russia, but it isn’t controlled from Moscow.

Bottom line – if you are a value hound and are interested in buying your straw hats in January, it may be time to look overseas to both the foreign developed and emerging markets.

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The views expressed are for commentary purposes only and do not take into account any individual personal, financial, or tax considerations. It is not intended to be personal legal or investment advice or a solicitation to buy or sell any security or engage in a particular investment strategy.