Market Overview

The Great Valuation Debate: How To Spot Fairly Valued Stocks - Part 3

The Great Valuation Debate: How To Spot Fairly Valued Stocks - Part 3

After eight consecutive up days and green finishes seen in twelve of the last fourteen sessions, even the most ardent bulls will likely admit that a pause might be in order right about now.

So, with Ben Bernanke in his semi-annual chat with Congress Wednesday and Thursday, it appears that traders decided that a break in the joyride to the upside was indeed in order Tuesday.

Related: Ben Bernanke Gives Report on Semiannual Monetary Policy

However, one down day (amounting to a measly 32 Dow points) does not make a pullback. So, with traders basically waiting to see if Gentle Ben is going to change his tune on Capitol Hill this week, this would be a good time to finish up looking at the various valuation metrics.

What has been witnessed so far is that the different P/E ratios we've reviewed suggest that valuations are a tad above fair value, while the P/D ratios show that stocks are expensive relative to long-term trends and fairly valued when compared to the trends of the past 25 years.

This third segment will round out the analysis by reviewing the Price-to-Book, Price-to-Cash Flow, and Price-to-Sales ratios, as well as a composite model that takes various measures into account. Let's begin...

Related: The Great Valuation Debate: Navigating a 'New Era' Market - Part 1

Price-to-Book Value Ratio
Book Value is a measure of corporate net assets. The measure is also known as the shareholder's equity, and is defined as a company's total assets minus total liabilities. Book value can also be thought of as an estimate of what the company would be worth if it were liquidated. In this case, we're taking the book value of all the companies in the S&P 500.

When looking at the Price-to-Book Value ratio since the late 1970s, it becomes clear that the ratio rose steadily from the beginning to the end of the secular bull market that occurred from 1982 through 1999. As one might expect, the ratio then declined precipitously from 2000 through early 2009.

Therefore, it can be concluded that this indicator tends to rise and fall depending on investors' long-term view of the stock market.

Although the range of the indicator is very wide (the high for the P/B over the 35.5 years has been 5 and the low has been below 1.0) and available data only goes back to 1978, the average P/B over the period has been 2.38. Thus, the current reading of 2.50 would be considered a "fair" valuation - especially over the last 20 years or so.

Price-to-Cash Flow Ratio
By now, the "price" part of the ratio should be obvious. However, to be clear, the definition of cash flow for this calculation is as follows: cash flow is the sum of undistributed profits of non-financial corporations with inventory valuation and capital consumption adjustments and the consumption of fixed capital by non-financial corporations. Yea, that's a mouth full. And no, it's not recommended to calculate this on your own.

But, that's what the computers at Ned Davis Research are for. In looking at the P/CF chart from 1952, it is clear that the range of prices was fairly consistent from 1952 through 1974, from 1975 through 1997 and from 1998 forward. So once again, investors will need to decide which "valuation era" they are going to use.

The most recent quarterly data that is available is from March 31, 2013, and the current P/CF level is 14.1. Prior to 1997, the P/CF ratio had been above 12 only twice; once in 1961 and again in 1969. As such, the current reading of 14.1 would appear to be high.

However, since 1997, the average appears to be closer to 16. Therefore, the bulls will argue that stocks still have a fair amount of upside.
Frankly, both sides can be argued here. So, as has been the case with many valuation indicators, the investors will need to decide whether they are looking at the more recent era or the entirety of history.

Price-to-Sales Ratio
This indicator is a little different in that (a) the S&P Industrial Average is used; and, (b) 12-month sales totals are used in order to smooth things out.

The trend of valuation "eras" continues to apply to this indicator. The range was clearly defined from 1954 through the mid-1970s. Then the range moved down dramatically from 1974 through 1990 and moved much higher from 1995 forward.

However, the message from this indicator is quite clear. In short, stocks are overvalued from a Price-to-Sales ratio. Although the argument can be made that the current reading is about average since 2000, this just isn't enough time for a valuation indicator to be effective. As such, this one will have to be given to the bears.

Related: The Great Valuation Debate: Are Stocks Overvalued? - Part 2

Valuation Composite Model
Another way to play the valuation game is to build a model. For this particular model, price is compared to the 10-year averages of:

  • Earnings yield
  • Dividend yield
  • Book value yield
  • Real earnings yield
  • Real dividend yield
  • Earnings to bond yield spreads; and,
  • Dividend to bond yield spreads


One way to utilize this model is as a buy/sell indicator. From a big-picture perspective, the results aren't half bad since the model gave timely sell signals in front of the 1970's bear market, the 1980 decline, the 1987 crash and the bear market of 2000. To be fair, the model booted the 2008 credit crisis bear entirely. It has since rebounded a bit as the indicator gave a buy signal in mid-2010.

As a valuation indicator, the model's overall record hasn't been bad. When the model says stocks are undervalued, the S&P has gained at a rate of +12.8 percent per year since 1965. And when the model indicates that stocks are expensive, the S&P has lost an average of -4.2 percent per year.

What is the model saying now, you ask? Although it can be argued that the low interest rate environment may be "messing" with the model a bit, the reading is fairly bullish. In other words, based on all kinds of relative yield indicators, stocks remain a bit undervalued.

To summarize...
As was opined in the very beginning of this series, valuation, like beauty, lies in the eyes of the beholder. In fact, most investors tend to see what they want to see in these indicators. And the fact that the most recent readings of the valuation metrics have been so volatile forces investors to decide which "era" is more appropriate to consider.

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