Understanding U.S. Stock Market Valuation
April 26, 2016 | Your Finances
If you listen to the news cycle long enough, you’ll believe that the fate of your portfolio rests on the question of whether the market is cheap or expensive. A minute or so of surfing through financial news channels or websites should be enough to convince you that the question of valuation is one of the most often asked and pontificated questions in financial markets. Of course, every question about valuation produces a different, and often contradictory, answer. That’s because there is no shortage of ways to measure the value of U.S. stocks.
How the Market Is Valued
There are hundreds of individual metrics that can be used to assess the financial viability of a company or, in our case, an overall market. Some of these are used specifically by financial analysts, financial professionals and investment advisors to assess whether a company/market is fairly valued or not and why. It is a complicated question, not only because there are so many different metrics, but also because there are many different schools of thought as to what exactly constitutes overvaluation and undervaluation.
At Northwestern Mutual, we don’t hang our hat on one particular valuation measure but rather look at them holistically to guide our overall market return outlook. We seek to understand the various factors that contribute to corporate profitability and the consequences that different scenarios might have for stock shareholders. Our perspective is that a single valuation answer, per se, isn’t as important as the overall environment and context.
Let’s examine three of the most prominent valuation measures that currently help guide our outlook for U.S. stocks. Here is a look at each of those metrics and what each means for today’s market:
Stock Valuation Metrics
Price-to-Sales (P/S) expresses the relationship between a company’s sales and its stock price. Sales, which measures the quantity of goods or services that a particular company sells, is closely tied to overall U.S. economic growth. Basically, this ratio measures how much investors are willing to pay for each dollar of sales that a company generates. The higher the ratio, the more investors are willing to pay.
The S&P 500 currently trades at nearly 1.8 times current sales. From a historical point of view, that isn’t as high as the “bubble” market of the late 1990s, which soared to 2.25 times current sales. However, it is significantly above the levels that preceded the Great Recession in 2007, when the price-to-sales ratio registered 1.65. Put differently, the only time we have witnessed valuations above current levels are the years directly preceding the tech bubble popping. That’s enough for some analysts to declare that the market is overvalued.
Price-to-Earnings (P/E) compares the relationship between a company’s earnings and its stock price. This measure resides at the bottom of an income statement. Simply put, it is what is “left over” for stock holders after companies pay the expenses they incur.
Currently the S&P 500 trades at 18.7 times earnings. Many will note that this is above the long-term average (since 1954) of 16.7. However, it’s important to remember that it’s just an average, reflecting many different economic and inflation environments.
When inflation is high, investors historically have paid less for artificially inflated earnings. For example, in the 1970s, the S&P 500 often traded for a mere 10 times earnings. Conversely, when inflation is low, investors are willing to pay a higher amount for each dollar’s worth of earnings. U.S. inflation currently resides between 0 and 2 percent, and historically when this condition exists, the S&P 500 average P/E is 18.7. In other words, based upon this metric the U.S. market is currently trading at its historical average or fair value.
Price-to-Cash-Flow (P/CF) shows the relationship between a company’s cash flow and its stock price. For businesses, cash is king. While earnings can be managed or adjusted to a degree, cash flow is much harder to massage. An analysis of the aggregate cash flow of companies in the S&P 500 shows that valuations look relatively cheap through this lens.
Connecting Sales and Earnings
Sales reside at the top of an income statement and represent the quantity and price of goods sold. Expenses are incurred in the process of creating these sales. The two most notable expenses are commodity costs incurred to build the product and wages paid to the individuals to create and sell the goods. After subtracting these two expenses from sales, we are left with profit that is available to pay the investors who provided the company with money (capital) to operate; namely bondholders and stock shareholders. Bondholders take their share of this profit first, and whatever is left over is available as bottom-line earnings for stock shareholders.
The Recipe of the Past Meets the Reality of the Future
Over the past few years, U.S. and global economic growth has been relatively weak, which has resulted in restrained sales. This is why the price-to-sales ratio seems high. However, because commodity prices have declined and employee wages have been low, companies have had lots of profit available for bondholders and shareholders. Importantly for those who own stock, low interest rates have meant that bondholders have taken little profit, which, combined with low commodity and wage expenses, has meant that a large amount of top-line sales has made it all the way to stock shareholders.
We believe this past recipe will change because we anticipate the three important variables that have enabled it—wages, commodities and interest rates—will be rising in the future. Therefore, we need a “new recipe” to get earnings to equity holders. The only way this can happen, if expenses are rising, is through top-line sales growth. Given sales’ relationship with economic growth, this makes equity returns heavily reliant upon economic output. If overall nominal economic growth is forecasted at 3-6% over the next year, this is a good place to anchor your shorter-term U.S. return expectations.
Wrapping in Cash Flow
We currently view companies’ high level of cash as providing a margin of safety to our low- to mid-single-digit return outlook, allowing companies the flexibility to use cash in multiple ways to help ballast their share price. These can include dividend increases, stock buybacks and mergers/acquisitions. In fact, in the first quarter of this year, when the S&P 500 fell nearly 13 percent on two separate occasions, companies were large buyers of their own shares, according to Bloomberg L.P.
The Bottom Line
U.S. stocks are not screamingly cheap. Given our outlook for continued economic growth, however, we believe there is room for equity prices to move modestly higher.
Northwestern Mutual is the marketing name for The Northwestern Mutual Life Insurance Company, Milwaukee WI (NM) (life and disability insurance, annuities and life-insurance with long-term care benefits) and its subsidiaries. Northwestern Mutual Wealth Management Company®, Milwaukee, WI (NMWMC) (fiduciary and fee-based financial planning services), subsidiary of NM, federal savings bank. Northwestern Mutual Investment Services, LLC (securities), broker-dealer, registered investment adviser and member FINRA and SIPC.
The opinions expressed are those of NMWMC as of the date stated on this material and are subject to change. This material does not constitute investment advice, is not intended as an endorsement of any specific investment or security and is not a prediction of what will happen in the markets. Information and opinions are derived from proprietary and non-proprietary sources. Please remember that all investments carry some level of risk, including the potential loss of principal invested. No investment strategy can guarantee a profit or protect against loss.
Standard and Poor’s 500 Index® (S&P 500®) is a capitalization-weighted index of 500 stocks. The index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
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