BF-AF571_HULBER_G_20130816143313More fun with price-to-earnings ratios:

Earlier this month, we looked at the question of whether Stocks were Cheap or Expensive. That was a follow up to our glance at how much Earnings and Equities had rallied off the 2009 lows.

The problem is the many ways we can define earnings-per-share. Do we use analysts’ forward earnings estimates? Trailing 12 months reported earnings? GAAP? Operating earnings? Blame the accountant industry for lacking sufficient spine to create a formal, uniform consensus on exactly how we should be defining earnings-per-share.

Which earnings type we use is only the first issue we run into. The next concern is our data set. For example, the Merrill Lynch analysis look at 15 earnings measures, but used data that only went back as far as 1960. Yale University professor Bob Shiller’s database goes all the way back to 1871.

Choosing which data set to work with may create a different outcome. Merrill shows stock prices between moderately undervalued and fairly priced. Shiller shows equities as modestly over-valued. Note the choice we make when selecting data sets can have a very significant impact on the final numbers.

The reality is far more nuanced. We do not know if equities are either over or under valued, because we have no idea what future earnings are going to be. The debate about valuations often turns on which group’s forecast is going to be correct: Expansion or contraction. (We shall ignore the extremeists on both ends of the scale, as they are annoying little twerps who are almost never correct).

Consider how earnings might change in the near future: If the economy were to accelerate (Sequester ends? China improves? Europe recovers?) than earnings could increase significantly, thereby making stocks “suddenly” look cheap. The opposite of this is a US recession, where earnings fall 20-30%, making stocks appear pricey and due for a more significant correction than the 10-19% blips we have plowed through the past 5 years.

Perhaps a better answer to the question “Are stocks cheap or pricey?” is It depends upon what happens in the future.

It is a deeply unsatisfying answer to most people. That is mostly because of its characteristic of being a) true, and b) recognizing the inherent unknowable future as such, and therefor frustrating to those investors who cling to the illusion of clarity.

 

 

 

Previously:
The Flawed Fed Valuation Model  (February 5th, 2008)

Why Using P/E Ratios Can Be Misleading (March 21st, 2012)

Earnings and Equities had rallied off the 2009 lows. (July 22nd, 2013)

Stocks were Cheap or Expensive. (August 9th, 2013)

 

Source:
Price-to-Earnings Ratios Aren’t Always What They Seem
P/E Calculations Based on Differing Views of Earnings Paint Competing Pictures of the Market
Mark Hulbert
WSJ,August 16, 2013 
http://online.wsj.com/article/SB10001424127887323455104579014782497257644.html

Category: Earnings, Valuation

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

13 Responses to “How Future Growth Impacts Current Equity Valuations”

  1. Scott Frew says:

    Barry, if subsequent market performance provides a decent yardstick, then some sort of Shiller PE that normalizes earnings works extremely well to determine whether stocks are cheap or expensive. A more recent Cliff Asness paper is worth a look in this context, and in particular the table on page 3 ought to be of interest. Shiller PE on his website looks like it’s currently just under 24, fyi. That is not slightly overvalued; it’s solidly in the 9th decile. http://bit.ly/YThHQj

    • My issue is how long it can stay that way — consider how this would have done in the 1990s, first issuing a warning around 1996.

      THats the problem — Valuation makes for a poor timing metric oveR the short term.

  2. rd says:

    Corporate revenues need to increase. The S&P 500 Price to Sales ratio has been steadily rising over the past five years. We need a period of time where revenues are rising to the Price-to-Sales Ratio doesn’t have to rise to have stock prices go up. The economy was able to increase sales from 2003-2007 where the Price to Sales was at a constant level similar to today’s as shown below:

    http://www.multpl.com/s-p-500-price-to-sales

    Once the revenues stopped growing in 2007, the stock market collapsed to low levels exacerbated by the financial crisis. Today, dividend yields, CAPE, and Price to Sales Ratio are all at levels that are unsustainable without economic and revenue growth. We still have pretty high levels of indebtedness across the economy, so it is not clear we will get it through additional borrowing unless it is done at the Federal government level which seems highly unlikely in today’s political climate. Alternatively, the companies can get the revenues from growth in the rest of the world ex-US.

  3. [...] How future growth impacts current equity valuations.  (TBP) [...]

  4. ironman says:

    BR writes:

    The reality is far more nuanced. We do not know if equities are either over or under valued, because we have no idea what future earnings are going to be.

    It’s more nuanced than you think. Future earnings are extremely volatile (we’ll have a more up-to-date example tomorrow), but they’re almost not relevant because they don’t drive stock prices. Expectations for future dividends do, which are better described as being the reasonable expectation of the amount of earnings that will be sustained at defined points in the future.

    But even if you know what that looks like, and we do, the real question that needs to be answered is which future dividends?

  5. JROR says:

    I question the Shiller P/E methodology since I do not believe normalizing earnings throughout a 10 year period, certainly the last 10 years, makes much sense. Perhaps it works for well established firms whose businesses have not changed but – and I candidly admit that I don’t have the data here – how much has the composition of the S&P changed? Perhaps if the Shiller methodology eliminated outliers such as 2009 and a really good year it would be more convincing but given how much things change for many companies, certainly the smaller cap firms that I follow, there is too much changing from a bottom’s up perspective. Does that normalize when we aggregate everything? I haven’t run that study.

  6. [...] Barry Ritholtz, “We do not know if equities are either over or under valued, because we have no idea what future earnings are going to be. The debate about valuations often turns on which group’s forecast is going to be correct: Expansion or contraction.”  (Big Picture) [...]

  7. Lamont says:

    “If the economy were to accelerate (Sequester ends? China improves? Europe recovers?) than earnings could increase significantly, thereby making stocks “suddenly” look cheap. ”

    Wouldn’t inflation increase significantly too, pushing up rates and commodity prices again? What would higher rates (even much higher than now) do to housing? How would higher commodity prices affect consumer spending? What would higher interest rates do to multiples? Wouldn’t that force the end of all QE? Wouldn’t stronger global growth result in more money leaving the US (rather than everyone piling into the SPY and IWM)? I wouldn’t be so sure this scenario of the sequester ending, China improving, and a European recovery would necessarily push the US equity markets higher. There is a very good case that can be made that it would push them lower. But cheaper… yes, but probably on the back of energy and multi-national industrials (like in 2007 and early 2008), and as we see housing and the US consumer remain in the dumps.

  8. [...] A look at earnings multiples | The Big Picture Asks if stocks are cheap or expensive? Based on PE ratios, valuations all depends on future EPS… and nobody know what the future holds: “It is a deeply unsatisfying answer to most people… who cling to the illusion of clarity.” [Or, as I like to say, every economist, analyst & money manager puts his pants on the same way as I, so they know nothing more about the future than I.] #Expert bias [...]