Notes on Stock Valuation

[nodoodahs]

First, the disclaimer: We could debate how to value the "market" all day, but I say to you now, the "market valuation" is moot to an investor. To wit: if I were to have created an index of beauty for the 500 women with the highest GPA in the senior class at your alma mater, and weighted it based on GPA, I might have said, "Gee, the 'market' sure is fat and has limp, lifeless hair this year." Does that mean anything to you, if the five girls that you're dating look good?

Now, the math!

http://www.moneychimp.com/articles/valuation/stockvalue.htm

Using the "perpetual growth" model, the PE of any stock should equal 1 / (D - G) where D is the desired "discount rate" (fancy way of saying target return) and G is the actual growth rate of earnings. We apply this concept to the S&P 500. The long term earnings growth of the S&P 500 is said to be 6%. The desired rate of return should be higher than that of a "risk free" investment, say for instance the 10 year Treasury. Historically since the 1960's that yield is around 7% on average. Today that yield is 4.4%, let's say 4.5% for round numbers.

How much higher than bond yields should our discount rate be? For purposes of illustration only, I shall use a modified "Fed Model." This model uses inflation as our guide ... conventional economists would (mis)use CPI for this. Since 1925, the CPI has averaged 3% annually, and that is close enough for government work to today's CPI. The CPI method would suggest a discount rate of 10% for historical purposes and 7.5% for today's environment. Unconventional non-economists (like me!) and some unconventional (re: Austrian) economists view inflation as a monetary phenomenon and I for one prefer to use M3 as my measure. Historically this has grown at 8% annually and today's figure is roughly 4.5% (nice round number). This yields a discount rate of 15% for historical purposes and 9% for today's environment.

So the "target" PE for the "market" is, according to the Fed model:

Historic/CPI 25.00
Current/CPI 40.00
Historic/M3 11.11
Current/M3 33.33

Now let's just assume your discount rate is based on the average annual performance of the market - you want to meet that historical average. That historical average is said to be anywhere from 10% to 11.5%. From the end of 1982 that average is 10%. Over the last 10 years it's 8%.

8% discount = PE of 50
10% discount = PE of 25.46
11.5% discount = PE of 18.61.

I can't resist messing with GOOG.

I use a three stage model here, math is available at the link above, with 35% growth over the next 5 years, 20% growth over the years 6-10, and reverting to 6% growth thereafter. A discount rate of 11.5% gives us a PE for GOOG of 93.81! However, a more conservative "Fed model" M3-based historical discount rate of 15% gives us a PE for GOOG of 51.63!

Stepping the growth down to 25% over the next 5 and 15% over the five following, reverting to 6% thereafter, we get PEs of 54 and 31!

Beauty, like stock valuations, is in the eye of the beholder. I hope this gives some insight into how to value a stock or the "market" based on your incoming assumptions, and on how the analysts "game" the valuations by changing assumptions ...
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I haven’t seen a beatin’ like that since somebody stuck a banana in my pants and turned a monkey loose.

[rffrydr]

Speaking of bi-polar, are (euro) banks "cheap"? Yes they are....oh, no they are not. The economic cycle is not the risk. Not even the "need" to recapitalize.

The markets, in a tantrum, don't want 'em. But, be careful, the parent sovereigns just may take 'em away. It's the early nineties--in reverse! But are they cheap? No ratio will tell.

But also consider Cemex: this stock should rise and fall with the vicissitudes of commerce. But it has debt. Company killing debt-- with trigger "covenants" and big currency twist. If it turns a little it turns a lot. No ratio will tell. Was this not also the condition in '08, the great deleveraging?

A radical proposition: Perhaps this should be the ONLY condition in which an individual investor should invest. --The ONLY condition which his judgment is as good as any professional. If nothing else it's a guarantee you get in "cheap."
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Today is the Tomorrow you worried about Yesterday!

[nodoodahs]

Your thoughts (above) are why I said this:

[rffrydr]

Right....and the discount rate applied from, say 1955 to 1989, the Boomer rabbit in the closed snake of a cold-war economy, is gonna be a lot different from the discount rate 1991-present, as wages freeze with population and world production and tech threatens overcapacity. Look what it's doing to the pension (legacy) maths right now.

Generally structural dis-inflation should buoy PEs and rising inflation cap them. But then, that gets all mixed up: we already saw the later with the oil majors in '08 and the extreme opposite with asian outsourced tech. These sorts of calculation raise more questions than they answer and like all "facts" need to be interpreted. Biryini is doing just that, praying for higher rates. Japan CB even gave it try once, and Trichet just recently. Ridicule from the believers both times. These ratios are supposed to allow us to equate relative valuations over long periods of time--and for that they seem to work alright. For traders they'll steer you into a ditch. Look at what a human pretzel Hussman has twisted himself into!

My favorite is the "percent chance of recession" usually based on credit spreads of last selldowns and the degree of selldown. In fact the selldowns were binary and the presumption of infinite liquidity at any price proved a myth. Credit spreads are great, but in times of world panic one needs a jaundiced-eye. Indeed, it's the first indicator for me, of whom NOT to listen to.

At the time of this post, there was in fact a "new and improved" metric, the PEG ratio, and earnings yield was what stock picking was all about (against benign "normative" back rates). That ultimate inversion of re-defining abject risk in terms of the safety of "yield" was symptomatic of the "Greed born of Fear" era that survived our ultimate millennial top, the Dot-Bomb. There's always a "background" assumed in these simple maths--like there will be banks!

BTW if Berkeshire is selling for cash plus one--the world is on sale.
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Today is the Tomorrow you worried about Yesterday!

[nodoodahs]

Normative does NOT mean "normal"

Normative is a viewpoint predicated on a belief in "what should be", whereas positive is a viewpoint predicated on an observation of "what is".

Normative might say "valuation ratios should move with long-term stable estimates of growth in earnings compared to a discount rate based on general interest rate and inflation parameters; therefore you cold-heartedly buy what is acceptably below the indicated ratio".

Positive might note that "valuation ratios are unstable because the market is irrational; however, there is a tendency to revert to the mean, therefore serious divergences in valuation ratios might represent buying opportunities" or note that "valuation ratios are unstable because the market is irrational; therefore they are useless", or some other construct, based on observed reality and inductive reasoning.
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I haven’t seen a beatin’ like that since somebody stuck a banana in my pants and turned a monkey loose.

[rffrydr]

What's "normative"? Post war, baby-boom fueled inflationary globalization? Or, 25 year grind down on those yields? Genetic hybridization fits which trend?

Growth comes front and back. Mouths are just one measure. The GOOG btw hasn't got any cheaper.
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Today is the Tomorrow you worried about Yesterday!

[nodoodahs]

[HenryTo]

Ed Yardeni on S&P 500's valuations vs. U.S. Treasury yields:

http://blog.yardeni.com/2011/10/valulation-bond-yield.html