Should investors care about valuation?

Rich Rosen, Portfolio Manager | November 25, 2013

  • Is valuation an effective tool for deciding on whether to invest in a stock?
  • We look at other drivers of a stock’s worth
  • Earnings and earnings growth could be more useful in evaluating a stock’s worth

Many of the market experts paraded around on the business programs, when asked about their forecast for stocks, often begin with a comment about valuation. But really, how effective is valuation as a gauge for determining whether it is a good time to invest in stocks?

What does valuation mean anyway? The most common measure of valuation starts by looking at the market’s P/E, or how much investors are presently willing to pay for one dollar’s worth of future earnings. Using prior cycles as a benchmark for what the norm should be, you can then conclude whether the market is cheap or expensive.

Looking at the market based on valuation: How helpful is it? While comparing the valuation of stocks today to prior cycles certainly has curb appeal as a measuring stick, recent results would leave you scratching your head as to its value. Consider the last four years of market data (well, almost four years, anyway), as summarized below. At the beginning of 2010, the market was valued at 15 times what were consensus earnings expectations for that coming year. Just two years later, that valuation had declined by nearly 20%, to 12x earnings. Why should that have happened? In fact, the environment for stocks improved during the two years, as earnings soared by 40%, and bond yields shrunk, thus making bonds less attractive than stocks. Was the market really overvalued at the start? Before trying to answer that question, take a look at the market’s returns over the following 22 months….a period in which interest rates rose (making bond returns more competitive), and the two-year earnings growth slowed dramatically, to roughly 14%. Over this period of time, the market P/E exploded, from 12.2x forward earnings to 15.1x, an expansion of nearly 24%. So, the ‘valuation’ of the market contracted by nearly 20% during a two year period of accelerating earnings growth and then expanded by nearly 25% during the following two years, when earnings growth slowed and interest rates rose, leaving the market at roughly the same valuation level as it was at the beginning of our exercise.

Date

S&P 500

Next Yr EPS (E)

P/E

P/E chg

10yr UST

10/31/2013

1756.5

$117.00

15.1

1.9

2.56%

12/31/2012

1426.2

$108.00

13.2

1

1.76%

12/31/2011

1257.6

$102.63

12.2

-1.35

1.88%

12/31/2010

1257.6

$92.60

13.6

-1.4

3.30%

12/31/2009

1115.1

$74.24

15

3.84%

Source: Columbia Management Investment Advisers, LLC, October 2013.

What, then is the message about the usefulness of valuation when making investment decisions? Our belief is that perceived normal valuation is too arbitrary a tool to spend a lot of time to focus on, unless the discrepancy can be measured in multiple standard deviations from the baseline. As investors, history has taught us that earnings and earnings growth are what drives stocks over time. That was proven in the two years ending in 2011 when stocks appreciated, even in the face of a 20% drop in valuation. During recession, stocks generally go down because earnings decrease. As to valuation, the market doesn’t like inflation (because the quality of earnings stink), and hates deflation (earnings growth is harder to come by) and uncertainty (the hardest variable to get a grasp on). To us, the four year valuation volatility had more to do with rising and falling inflation/deflation fears, rather than stocks being overvalued or undervalued.

Our conclusion: We would counsel investors who invest in stocks that doing so is a long-term proposition, and valuation volatility, such as we have seen over the last few years is not to be unexpected. Frankly, it is one of the reasons that stocks outperform bonds and cash over time. Earnings and earnings growth are the most important drivers of stocks, with changes in the outlook for inflation or deflation the true determinant of appropriate valuation for any given period of time.

Rich Rosen

Portfolio Manager
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