Time for Value?

Are stocks expensive now?

Photo: Victor Hancek. Source: Picjumbo

That depends on what you mean by expensive. Unlike rare art, fine wine, and gold, stocks have an intrinsic value. They represent ownership in an enterprise that can potentially generate earnings and dividends for investors. This leads us to the fundamental paradox of investing: 100% of what we know about a company is based on the past, but 100% of a company’s value is based on a forecast of the future: future sales, future earnings, and ultimately future free cash flow available to investors.

In most cases, the past is prologue. What has happened in the recent past is likely to continue into the near future: Apple will keep selling iPhones, Ford will build cars, and Colgate will offer products to make our teeth clean and healthy. But every few years something comes along to disturb this pattern. In 2008 and 2009, homebuilders like Lennar couldn’t give away their products – and BankAmerica and Citigroup could write mortgages. There was a lot of uncertainty about the future, and the market’s valuation was a lot lower.

Source: Chartsbin.com

If you look at stocks around the world, some places stand out. Markets in countries with a lot of uncertainty in their economic and political outlook look cheap when compared to their earnings. Markets will a lot more political and financial stability look expensive. High PE countries are ones where the market expects a lot of stable growth. Low PE countries, not so much.

Valuation is always a question about the future. When growth looks like it’s picking up, market multiples move higher. When growth is slowing, multiples move down. Deciding whether a stock or stock market is expensive or cheap depends on your outlook for growth. If you expect growth to move sustainably higher, then a high valuation might be justified. But if you think growth is likely to fall back to its median rate, then a median valuation is more appropriate.

Photo: David. Source: Pixabay

The question of whether stocks are expensive reminds me of that old rejoinder of the New England farmer when someone asked how he was doing: “Compared to what?” Every day, the market votes on earnings, growth, and stability. In many ways, it’s like the weather. If you don’t like what it’s saying right now, stick around. It will change.

Douglas R. Tengdin, CFA

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