Does valuation matter?
Many analysts consider the stock market expensive right now. They look at high-flyers, like Facebook, Netflix, and Tesla—with their eye-popping PE ratios, and conclude that the market has gone crazy. Other folks note that these companies are new, and that they’re priced for significant future growth. If you look at the rest of the market—with pedestrian names like Exxon, Apple, and Caterpillar—valuations are far more reasonable. Which is it?
The market has always been an amalgamation—some companies are expensive, some companies are cheap. When a company has a high valuation, investors are looking for them to grow their revenue, cash flow, and earnings significantly faster than the economy. That’s the case with many concept companies right now. They have the potential to disrupt the economy in significant ways—like Amazon, or Uber. In the process, they carve out a new niche for themselves.
Cheap stocks, on the other hand, are cheap for a reason. There are problems on the horizon—like falling oil and iron ore prices, or there are regulatory concerns, or environmental issues threaten the company. Low valuations don’t just happen. They have to be earned—the same as high valuations. Prices are just projected cash flows discounted back to their present value. For the price to be low, either the expected cash flows are low, or the discount rate is high, or both. And when things get more risky, discount rates rise.
But the world has a funny way of not ending. That’s why the cheapest assets tend to perform better over time. When the market’s fears don’t play out, valuations move back up to normal. Conversely, when the latest hot trend turns into a normal—as opposed to disruptive—growth opportunity, valuations fall from stratospheric levels to just high. Mean-reversion works both ways. There are times when value stocks are in demand, and other times when growth stocks outperform.
It all depends on what you’re looking for from your investments. Do you want a safe, steady stream of growing dividends? Then your portfolio may not grow as fast as the market. Do you want disruptive, transformative growth? Then get ready for some gut-wrenching volatility. And be careful that you don’t panic when things look really bad. That’s often when they’re about ready to turn around—like March 2009, or October 1998. The best way to turn volatility into permanent losses is to panic.
Valuation matters. It shows how much growth the market expects, and also how risky a business might be. Buying stocks isn’t that different from buying anything else: you get what you pay for. You just have to know what you’re looking for.
Douglas R. Tengdin, CFA
Chief Investment Officer