The price is right

William Mack, Butterfield

Whether shopping for groceries, purchasing a plane ticket or paying for a car repair, informed consumers must consider if a product or service purchased is worth the price. Value is at the heart of virtually every consumer purchase.

Yet even as people almost inherently understand value in their everyday purchases, they frequently overlook the important concept of value when making portfolio decisions.

With the understanding that each share represents fractional ownership of a public company, a shareholder has an implicit claim on future profits. Since nobody knows with certainty what a company’s future profits will be, he must necessarily estimate that future profitability in order to calculate a stock’s value.

Of the numerous valuation methods, price to earnings is the simplest and most commonly used. As an example, semiconductor manufacturer Intel, recently trading at around $27.50 per share, is expected to earn $2.45 a share in 2012. The resulting price earnings multiple is around 11.2X ($27.5 divided by $2.45). This computation is the first step in valuing a stock, providing a framework by which to more fully assess its attractiveness.

A full assessment of value – a relative term – depends on numerous independent, qualitative and quantitative variables. Value reflects expectations for long term profit growth as well as the probability of achieving expected future profit growth. In analysing a stock, one should then ask, “how does today’s value compare to historical valuations for the security and how does it compare to industry peers?”

Since most investors have opinions about broader economic growth and the attractiveness of the stock market in general, I will discuss valuation in the context of the broad market. The process is no different than valuing an individual security.

Consider the S&P 500 Index, the most closely followed index in the world, comprised of the 500 largest US-based stocks. The index’ earnings represent a weighted average of the per-share profits of each member company.

After generating about $95 in 2011 profits, the S&P 500 Index consensus earnings estimate for 2012 is roughly $106 a share. Recently trading at 1375 the S&P 500’s P/E is 14.5 times actual 2011 profits and 13 times forecasted 2012 profits.

By historical standards, stocks are cheap, as the 14.5 times P/E on the S&P 500 is more than 25 per cent below the average since 1990 (of 19.7x). Indeed, if you had bought the S&P 500 on the only two occasions that it reached similar valuation lows, in 1990 and 1994, then you would have earned 13.3 per cent and 26.2 per cent annually over the successive five-year periods. Indeed, after 2008, stocks were valued at this comparable level, and have averaged 13 per cent returns in the three-plus years since then.

With history on our side, what is keeping investors from going ‘all in’? Some believe that recent returns have discounted much of the expected earnings improvements. They argue that stocks, as measured by the S&P 500 Index, have risen around 10 per cent already in 2012, and 25 per cent since their early October 2011 low, far outpacing underlying earnings growth estimates.

Other investors think there is too much uncertainty, and point to a number of lingering issues. First, the fate of Greece and the EU – teetering on regional recession – has yet to be fully resolved. China, a key engine for global growth, might be heading for a hard landing, ie, slow growth. We should not forget that economic recovery in the US, the world’s largest economy, may not pan out in 2012. Even if it this year’s expansion is real, there is the possibility that profit growth in the coming years could be well below historic levels.

These are just some of the issues investors face when trying to gauge the sustainability of the market’s recent run. Today’s low valuation multiple quantifies that skepticism. As an investor, one must make a qualitative judgment as to whether these concerns are warranted.

It appears that the global economy is working through its myriad problems, stocks appear to represent a compelling value, even compared to past market peaks, as seen in the table.

This most recent peak valuation is more than 43 per cent below the 2000 high of 33.8x. Although nobody expects valuations to reach 2000 levels, just to get back to the market’s 2007 peak, implies another 24 per cent rise from recent levels.

While abnormally high valuations (eg, late 90’s/early ’00) should warrant caution for investors, abnormally low valuations provide a cushion against potential declines. Consider that even if you had purchased stocks at the 1990 high, thinking 15.4x was a reasonable valuation, you would have generated 8 per cent a year (with dividends), a fair return in the context of three recessions, and a few bear markets over that span.

Investors will always face economic and political cross-currents, amid a constant barrage of often misleading information. If there is any single guiding principal that has endured it is the concept of valuation. Applied with discipline this investment tool provides a measure of protection against overly bullish market sentiment, while also allowing investors to take advantage of opportunities in stocks.

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